UNDERSTANDING SHORT SELLING

An investor who buys and owns shares of stock is said to be long in the stock or to have a long position. An investor with a long position will make money if the price of the stock increases and lose money if it goes down. In other words, a long investor hopes that the price will increase. Now consider a different situation. Suppose you thought, for some reason that the stock in a particular company was likely to decrease in value. You obviously wouldn’t want to buy any of it. If you already owned some, you might choose to sell it. Beyond this, you might decide to engage in a short sale. In a short sale, you actually sell a security that you do not own. This is referred to as shorting the stock. After the short sale, the investor is said to have a short position in the security.

Financial assets of all kinds are sold short, not just shares of stock, and the terms “long” and “short” are universal. However, the mechanics of a short sale differ quite a bit across security types. Even so, regardless of how the short sale is executed, the essence is the same. An investor with a long position benefits from price increases, and, as we will see, an investor with a short position benefits from price decreases. For the sake of illustration, we focus here on shorting shares of stock.

Basics of a Short Sale

How can you sell stock you don’t own? It is easier than you might think: You borrow the shares of stock from your broker and then you sell them. At some future date, you will buy the same number of shares that you originally borrowed and return them, thereby eliminating the short position. Eliminating the short position is often called covering the position or, less commonly, curing the short.

You might wonder where your broker will get the stock to loan you. Normally, it will simply come from other margin accounts. Often, when you open a margin account, you are asked to sign a loan-consent agreement, which gives your broker the right to loan shares held in the account. If shares you own are loaned out, you still receive any dividends or other distributions and you can sell the stock if you wish. In other words, the fact that some of your stock may have been loaned out is of little or no consequence as far as you are concerned.

An investor with a short position will profit if the security declines in value. For example, assume that you short 1,000 shares of Xerox Corp. (XRX) at a price of $20 per share. You receive $20,000 from the sale. A month later, the stock is selling for $16 per share. You buy 1,000 shares for $16,000 and return the stock to your broker, thereby covering your short position. Since you received $20,000 from the short sale and it is now costing you only $16,000 to cover the same 1,000 shares, you will be making $4,000 in profit from your short position.

Conventional Wall Street wisdom states that the way to make money is to “buy low and sell high.” With a short sale, we hope to do exactly that, just in opposite order – “sell high, and re-buy low.” If a short sale strikes you as a little confusing, it might help to think about the everyday use of the terms. Whenever we say that we are “running short” on something, we mean we don’t have enough of it. Similarly, when someone says “don’t sell me short,” they mean don’t bet on them not to succeed.

Some Details of Short Selling

When you short a stock, you must borrow it from your broker, so there are various requirements you must fulfill. First, there is an initial margin and a maintenance margin. Second, after you sell the borrowed stock, the proceeds from the sale are credited to your account, but you cannot use them. They are, in effect, frozen until you return the stock. Finally, if any dividends are paid on the stock while you have a short position, you must pay them.

To illustrate, we will again create an account balance sheet. Suppose you want to short 100 shares of Texas Instruments, Inc. (TXN), when the price is $30 per share. This means you will borrow shares of stock worth a total of $30 x 100 = $3,000. Your broker has a 50 per cent initial margin and a 40 percent maintenance margin on short sales. An important thing to keep in mind with a margin purchase of securities is that margin is calculated as the value of your account equity relative to the value of the securities purchased.

With a short sale, margin is calculated as the value of your account equity relative to the value of the securities sold short. Thus, in both cases, margin is equal to equity value divided by security value. In our Texas Instruments example, the initial value of the securities sold short is $3,000 and the initial margin is 50 percent, so you must deposit at least half of $3,000, or $1,500, in your account. With this in mind, after the short sale, your account balance sheet is as follows:


Assets
 
Liabilities and Account Equity
 
Proceeds from sale
$3,000
Short position
$3,000
Initial margin deposit
1,500
Account equity
1,500
Total
$4,500
Total
$4,500

As shown, four items appear on the account balance sheet:

1. Proceeds from sale. This is the $3,000 you received when you sold the stock.

This amount will remain in your account until you cover your position. Note that you will not earn interest on this amount—it will just sit there as far as you are concerned.

2. Margin deposit. This is the 50 percent margin that you had to post. This amount will not change unless there is a margin call. Depending on the circumstances and your particular account agreement, you may earn interest on the initial margin deposit.

3. Short position. Because you must eventually buy back the stock and return it, you have a liability. The current cost of eliminating that liability is $3,000.

4. Account equity. As always, the account equity is the difference between the total account value ($4,500) and the total liabilities ($3,000).

We now examine two scenarios:

i. The stock price falls to $20 per share, and

ii. The stock price rises to $40 per share.

If the stock price falls to $20 per share, then you are still liable for 100 shares, but the cost of those shares is now just $2,000. Your account balance sheet becomes:

Assets
 
Liabilities and Account Equity
 
Proceeds from sale
$3,000
Short position
$2,000
Initial margin deposit
1,500
Account equity
2,500
Total
$4,500
Total
$4,500

Notice that the left-hand side doesn’t change. The same $3,000 you originally received is still held, and the $1,500 margin you deposited is still there also. On the right-hand side, the short position is now a $2,000 liability, down from $3,000. Finally, the good news is that the account equity rises by $1,000, so this is your gain. Your margin is equal to account equity divided by the security value (the value of the short position), $2,500/$2,000 = 1.25, or 125 percent.

However, if the stock price rises to $40, things are not so rosy. Now, the 100 shares for which you are liable are worth $4,000:

Assets
 
Liabilities and Account Equity
 
Proceeds from sale
$3,000
Short position
$4,000
Initial margin deposit
1,500
Account equity
500
Total
$4,500
Total
$4,500

Again, the left-hand side doesn’t change. The short liability rises by $1,000, and, unfortunately for you, the account equity declines by $1,000, the amount of your loss. To make matters worse, when the stock price rises to $40, you are severely under-margined. The account equity is $500, but the value of the stock sold short is $4,000. Your margin is $500 / $4,000 = 12.5 percent. Since this is well below the 40 percent maintenance margin, you are subject to a margin call. You have two options: (1) buy back some or all of the stock and return it, or (2) add funds to your account.

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Comments 3 comments

Larry Wall 3 years ago

Sounds to risky for the average investor and I would be concern about any broker who would suggest that one of his clients do what you have outlined. It is way too risky.


fitzjkenny 3 years ago Author

Thanks Larry for your concerns.

But The way the short selling system works is that when the person borrows the Shares to short, he is not permitted to withdraw the money until he replaces the shares. Also, any dividend earned on the short shares in the given period goes to the original stock owner and not to the borrower of the shares, meaning that the original owner has nothing to lose i.e. No Risk!!

The advantage to the Borrower to is that, he does not need to own the shares in order to make money from them, his risk however, is the money he would lose in case the stock price goes up instead of going down as anticipated. It is arbitrage profit he wants to make so he is aware of the risk involved.


Larry Wall 3 years ago

When it comes to stocks, I not sure everyone knows the risk, regardless of whether they buy outright, buy on margin or buy short. I have know people who keep all their investments in one company and lost it all. I have know others who could not answer the margin call. I do not know anyone who has used the method outlined by you, but if you buy short because someone told you that "this stock cannot miss" you could take a soaking. I have always had a diversified portfolio, even when I was first starting to contribute to my 401k more than 20 years ago. I came through the 2008 fall better than many friends. Some are making more than me right now because of the rising market. However, stocks are like gravity. Everything that goes up, must come down. The short system may work for some, but they need to discuss it in detail with their own financial adviser and not venture out on their own.

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