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Short selling
Short selling
Authors: TradingDay.com, -oo0(GoldTrader)0oo-, Goodemi, OwenX, JJay, Pakaran
Publisher: TradingDay.com, Version: 1
Overview
In finance, short selling or "shorting" is a way to profit from the decline in price of a security, such as stock or a bond. Most investors "go long" on an investment, hoping that price will rise. To profit from the stock price going down, a short seller can borrow a security and sell it, expecting that it will decrease in value so that they can buy it back at a lower price and keep the difference.
Example
For example, assume that shares in XYZ Company currently sell for $10 per share. A short seller would borrow 100 shares of XYZ Company, and then immediately sell those shares for a total of $1000. If the price of XYZ shares later falls to $8 per share, the short seller would then buy 100 shares back for $800, return the shares to their original owner, and make a $200 profit. This practice has the potential for an unlimited loss, for example, if the shares of XYZ that one borrowed and sold in fact went up to $25, the short seller would have to buy back all the shares at $2500, losing $1500.
However, the term "short selling" or "being short" is often used as a blanket term for all those strategies which allow an investor to gain from the decline in price of a security. In fact, what is many times labeled short selling is options or futures activity, since this activity greatly magnifies the gain that results from a securities price loss.
History
Short selling has been a target of ire since at least the 18th century when England banned it outright. It was also considered a disreputable business practice because of the perceived magnifying effect it had on the violent downturn in the Dutch tulip market in the 17th century. Short sellers are widely regarded with suspicion because, to many people, they are profiting from the misfortune of others. However, academic studies have generally lauded short-selling as an important contribution to stock market efficiency.
Moreover, less than 5% of all shorts are done by public investors and traders, whereas at least 95% of short sales are done by broker-dealers and market makers who do not even always have to own shares to sell them (i.e. naked short selling).
The term "short" was in use from at least the mid-19th century. It is commonly understood that "short" is used because the short seller is in a deficit position with his brokerage house.
Short sellers were blamed (probably erroneously) for the Wall Street Crash of 1929. Regulations governing short selling were implemented in 1929 and in 1940. Political fallout from the 1929 crash led Congress to enact a law banning short sellers from selling shares during a sharp downturn. President Hoover condemned short sellers and even J. Edgar Hoover said he would investigate short sellers for their role in prolonging the Depression. Legislation introduced in 1940 banned mutual funds from short selling (this law was lifted in 1997).
Some typical examples of mass short-selling activity are during "bubbles", such as the Internet bubble. At such periods, short-sellers sell hoping for a market correction. Food and Drug Administration (FDA) announcements approving a drug often cause the market to react illogically due to media attention; short sellers use the opportunity to sell into the buying frenzy and wait for the exaggerated reaction to subside before covering their position. Negative news, such as litigation against a company will also entice professional traders to sell the stock short.
Mechanism
Short selling stock consists of the following:
- An investor borrows shares, but since there is a general rule in the United States that one must only borrow money based on shares up to 50 percent of the shares value, one must deposit 50 percent of the value of the shares in cash with one's brokerage firm.
- The investor sells them and the proceeds are credited to his account at the brokerage firm.
- The investor must "close" the position by buying back the shares (called covering) - If the price drops, he makes a profit. Otherwise he makes a loss.
- The investor finally returns the shares to the lender.
The short seller owes his broker and must repay the shortage when he covers his position. Technically, the broker usually in turn has borrowed the shares from some other investor who is holding his shares long; the broker itself seldom actually purchases the shares to loan to the short seller.
In the U.S., in order to sell stocks short, the seller must arrange for a broker-dealer to confirm that it is able to make delivery of the shorted securities. This is referred to as a "locate", and it is a legal requirement that U.S. regulated broker-dealers not permit their customers to short securities without first obtaining a locate.
Brokers have a variety of means to borrow stocks in order to facilitate locates and make good delivery of the shorted security. The vast majority of stocks borrowed by U.S. brokers come from loans made by the leading custody banks and fund management companies. Sometimes, brokers are able to borrow stocks from their customers who own "long" positions. In these cases, if the customer has fully paid for the long position, the broker can not borrow the security without the express permission of the customer, and the broker must provide the customer with collateral and pay a fee to the customer. In cases where the customer has not fully paid for the long position (meaning, the customer borrowed money from the broker in order to finance the purchase of the security), the broker will not need to inform the customer that the long position is being used to effect delivery of another client's short sale.
Short interest data, e.g. the short interest ratio can be useful to spot trends in stock price movements.
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This article uses
material from the Wikipedia article "Short selling" (Version
16:13, 12 September 2006 ) . It is licensed under
the GNU Free Documentation License. Permission is granted to copy,
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