Short selling

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In finance, short selling is selling something that one does not (yet) own.

Contents

Stocks

Typically, this refers to stock shares. In a sense, short selling stocks means to own a negative amount of stocks. A short seller is taking a fundamentally negative, or "bearish" view on a stock, and believes that the stock is "overvalued" at the time of the short sale. The short seller believes that the price of the shorted stock will fall, and it will be possible to buy at a lower price whatever was sold, thereby making a profit. The act of buying back the shares which were sold short is called 'covering the short'. day traders and hedge funds will often use short selling to allow them to profit on trading in stocks which they believe are overvalued, just as traditional "long" investors attempt to profit on stocks which are undervalued by buying those stocks.

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 (see list below). 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.

Leading Lenders of Securities to Broker-Dealers

  • State Street Bank (Boston)
  • JP Morgan Chase (New York)
  • Citibank (New York)
  • Mellon Bank (Pittsburgh)
  • The Bank of New York (New York)
  • The Northern Trust Company (Chicago)
  • Barclays Global Investors (San Francisco)
  • UBS (Zurich)

When a broker facilitates the delivery of a client's short sale, the client is charged a fee for this service. The fee takes the form of "short interest" which is typically accrued daily and charged monthly, starting on the day that the short sale settles, and concluding on the day that the short position is "closed out". This adds incremental "short financing cost" to the strategy of short selling, and therefore decreases the profit potential of short selling.

It should be noted that short selling by hedge funds frequently represents only one leg of a more complex set of transactions which fall into a broad range of investment strategies (see hedge fund).

Futures contracts

When dealing with futures contracts, being "short" means having the obligation to deliver (or buy back) something that was already sold. This is often an instrument used by producers or farmers to fix the price of goods they have yet to mine or grow.

Currency

To sell currencies short you borrow a currency and buy another currency with it. When the exchange rate has changed you buy the first currency again, this time you get more of it, and pay back the loan. Since you got more money than you had borrowed initially, you earn money.

History

It is possible that the term "short" derives from the name of a notorious stock broker of the 1920s that used the practice to defraud his customers (disputed). It is more commonly understood that the term "short" is used because the short seller is in a deficit position with his brokerage house. That is, he 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.

Risk

It is important to note that buying shares and then selling them (called "going long") has a very different risk profile from selling short. In the former case, losses are limited (the price can only go down to zero) but gains are unlimited (there is no limit on how high the price can go). In short selling, this is reversed, meaning the possible gains are limited (the stock can only go down to a price of zero), and the seller can lose more than the original value of the share, with no upper limit. For this reason, short selling is usually used as part of a hedge.

Many short sellers place a "stop loss order" with their stockbroker after selling a stock short. This is an order to the brokerage to cover the position if the price of the stock should rise to a certain level, in order to limit the loss and avoid the problem of unlimited liability described above. In some cases, if the stock's price skyrockets, the stockbroker may decide to cover the short seller's position immediately and without his consent, in order to guarantee that the short seller will be able to make good on his debt of shares.

Short selling is sometimes referred to as a "negative income investment strategy" because there is no potential for dividend income or interest income. One's return is strictly from capital gains.

Short sellers must be aware of the potential for a short squeeze. This is a sharp uptick in the price of a stock, caused by large numbers of short sellers covering their positions on that stock. This can occur if the price has risen to a point where these people simply decide to cut their losses and get out. (This may occur in an automated way if the short sellers had previously placed stop-loss orders with their brokers to prepare for this eventuality.) Since covering their positions involves buying shares, the short squeeze causes an ever further rise in the stock's price, which in turn may trigger additional covering.

On occasion, a short squeeze is deliberately induced. This can happen when a large investor (a company or a wealthy individual) notices many short positions, and buys many shares, with the intent of selling them to the short sellers who will be paniced by the initial uptick.

Short sellers who are borrowing money from their brokerage house also must be aware of the margin call, a demand for additional funds from their broker, because of, in the case of shorting, a rise in the price of the security being shorted.

Short sellers must also be aware of the potential for liquidity squeezes. This occurs when a lack of potential (long) buyers, or an excess of coverers, makes it difficult to cover the short sellers' position. Because of this, most short sellers restrict their activities to heavily traded stocks, and they keep an eye on the "short interest" levels of their short investments. Short interest is defined as the total number of shares that have been sold short, but not yet covered.

Strategies

One variant of selling short involves a long position. "Selling short against the box" is holding a long position on which one enters a short sell order. The term box alludes to the days when a safe deposit box was used to store (long) shares. The purpose of this technique is to lock in paper profits on the long position without having to sell that position. Whether prices increase or decrease, the short position balances the long position and the profits are locked in (less brokerage fees).

Opinions

Short sellers have a negative reputation to some. Businesses hate short sellers who target them, as the short selling drives down the price of their stock and puts the short sellers in a position where they benefit from the business's misfortune, which seems like a ripe opportunity for conspiracies against the business, especially anonymous rumors. Others portray short sellers as ghoulish characters who hope for catastrophes. There was a practice in the late 19th century of borrowing people's shares, selling them, then floating horrible rumors in the media about the companies in question, driving the stock price down, then purchasing the shares back at the much lower price. Even today, short sellers have been known to create bear raids by selling blocks of shares that they do not own. In the US, to mitigate this problem, the SEC (Securities and Exchange Commission) has instituted an uptick rule. This states that a short seller cannot sell a stock short unless on an uptick or a zero-plus tick; this means the stock can only be sold short if the last non-zero "tick" (i.e. trade price) was higher than the preceding one. In doing so, US market regulators are trying to make sure that short sellers are not, by themselves, causing the price depreciation, and that downwards pressure on the stock price is balanced by new buying demand. Market Makers on the NASDAQ market are exempt from the uptick rule; other rules, such as ones involving Naked Short Selling are not rigidly enforced on them either. Some of the regulations involving short selling are also relaxed during non-regular market hours.

In the US, initial Public Offerings (IPOs) cannot be sold short for a month after they start trading. This mechanism is in place to ensure the stability of price of a company in its initial trading period. Canada and other countries do allow selling IPOs (including US IPOs) short.

However, on 2003-10-29 the SEC [1] (http://www.sec.gov/rules/other/34-50104.htm) announced a one year pilot program to suspend the uptick rule for 1000 listed and NASDAQ traded stocks selected from the 3000 most liquid securities.

Some typical examples of mass short-selling activity are during "bubbles", such as the Internet bubble, the cigar smoking fad or the Pokemon craze (all of which happened between 1995 and 2000 in the USA). At such periods, short-sellers sell hoping for a market correction. FDA announcments 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 exagerated reaction to subside before covering their position. Negative news, auch as litigation against a company will also entice professional traders to sell the stock short.

Advocates of short sellers have also stated that their scrutiny of companies' finances has led to the discovery of instances of fraud which were glossed over or ignored by investors who had held the companies' stock long. Some hedge funds and short sellers claimed that the accounting of Enron and Tyco was suspicious, months before their respective financial scandals manifested.

See also

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