short position: Definition and Much More from Answers.com
- ️Wed Oct 29 2003
In finance, short selling or "shorting" is a way to profit from the decline in price of a security, such as a stock or a bond. In contrast, investors who "go long" with an investment hope the price will rise.
To profit from the stock price going down, short sellers 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. The short seller owes his broker, who 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 lend to the short seller.[1] The lender of the shares does not lose the right to sell the shares. While the shares are lent, two investors have a right to sell the same shares. This has happened in 2007 in the UK with dramatic results, when shares in a Bank, Northern Rock, were £12 in February 2007 and £2 in September. Short sellers made over £1 billion in about seven months. [2]
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. Those strategies include buying options known as puts. A put option consists of the right to sell an asset at a given price; thus the owner of the option benefits when the market price of the asset falls. Similarly, a short position in a futures contract, or to be short a futures contract, means the holder of the position has the obligation to sell the underlying asset at a later date.
History
Short selling has been a target of ire since at least the eighteenth century when England banned it outright. It was perceived as a magnifying effect in the violent downturn in the Dutch tulip market in the seventeenth century.
The term "short" was in use from at least the mid-nineteenth 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 downtick.[citation needed] 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 1947). A few years later, in 1949, Alfred Winslow Jones founded a fund (that was unregulated) that bought stocks while selling other stocks short, hence hedging some of the market risk, and the hedge fund was born.[citation needed]
Some typical examples of mass short-selling activity are during "bubbles", such as the Dot-com 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. Because both the short seller and the original long holder can sell the same shares at the same time, selling pressures can be artificially magnified during such times, causing larger price drops than would be normally justified by the negative news.
During the Dot-com bubble, shorting a start-up company could backfire since it could be taken over at a higher price than what speculators shorted. Short-sellers were forced to cover their positions at acquisition prices, while in many cases the firm often overpaid for the start-up.
On 2003-10-29 the SEC announced a one year pilot program to suspend the uptick rule for 1,000 listed and NASDAQ traded stocks selected from the 3,000 most liquid securities.[3]
Mechanism
Short selling stock consists of the following:
- An investor borrows shares. (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 takes a loss.
- The investor finally returns the shares to the lender.
Securities lending
When you sell a security, you are contractually obliged to deliver it to the buyer. If you sell a security short without owning it first, you will have to borrow it from a third party to fulfill your obligation. Otherwise, you will fail to deliver, the securities won't settle, and you can expect a claim from your counterparty. Certain large holders of securities, such as a custodian or investment management firm, often lend out these securities to gain extra income. This is called securities lending. The lender receives a fee for this service. Similarly, retail investors can sometimes make an extra fee when their broker wants to borrow their securities. This is only possible when the investor has full title of the security, so it cannot be used as collateral for margin buying.
Major lenders
- Deutsche Bank (Frankfurt-am-Main, Germany)
- State Street Corporation (Boston)
- JP Morgan Chase (New York)
- Citibank (New York)
- Mellon Bank Corp. (Pittsburgh)
- Bank of New York (New York)
Naked short sale
A naked short sale is selling a security short without first ascertaining that one can borrow the security. In the US, making arrangements to borrow the securities first is often referred to as a locate. To prevent widespread failure to deliver securities, the U.S. Securities and Exchange Commission (SEC) has put in place Regulation SHO, which prevents investors from selling stocks short before doing a locate. Market makers do not have this restriction, as this would seriously restrict liquidity.
Concept
Short selling is the opposite of "going long." The short seller takes a fundamentally negative, or "bearish" stance, anticipating that the price of the shorted stock will fall (not rise as in long buying), and it will be possible to buy at a lower price whatever was sold, thereby making a profit ("selling high and buying low," to reverse the adage). The act of buying back the shares which were sold short is called 'covering the short'. Day traders and hedge funds 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.
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 lend to the short seller.[1]
For example, to establish a 1,000-share short position of a stock trading at $100 per share, a person would borrow 1,000 shares from someone and then immediately sell them at a per share price of $100. If the stock were to drop ten percent in value the short trader could then elect to cover the position by buying back 1000 shares at $90 per share, for a profit of $10 per share, or $10,000.
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 stock borrowed by U.S. brokers comes 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 cannot 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.
Most brokers will allow retail customers to borrow shares to short a stock only if one of their own customers has purchased the stock on margin. Brokers will go through the "locate" process outside their own firm to obtain borrowed shares from other brokers only for their large institutional customers.
Stock exchanges such as the NYSE or the NASDAQ typically report the "short interest" of a stock, which gives the number of shares that have been sold short as a percent of the total float. Alternatively, these can also be expressed as the short interest ratio, which is the number of shares sold short as a multiple of the average daily volume. These can be useful tools to spot trends in stock price movements.
Fees
When a broker facilitates the delivery of a client's short sale, the client is charged a fee for this service, usually a standard commission similar to that of purchasing a similar security. If the short position begins to move against you (rise in price), money will be removed from your cash account and moved to your margin account. If short shares continue to rise in price, and you don't have enough funds in your cash account to cover the position, you'll begin to borrow on margin for this purpose. At that time, you'll also begin to accrue margin interest charges. These will be computed and charged just as for any other margin debit. If you are short a stock while its ex-dividend date passes, the dividend will be deducted from your account to be paid to the person from whom the stock was borrowed. For some brokers, the short seller might not earn interest on the proceeds of the short sale or reduce outstanding margin amounts. The brokers generally do not pass this benefit on to the retail client unless the client is very large. What this means is that if you short sell $1000 of stock A and buy $1000 of stock B with the proceeds, you will lose the interest earned on $1000 of any cash balance in your account, and, if you don't have that big a cash balance, you'll have to pay interest on the difference.
Markets
Futures and options contracts
When trading futures contracts, being 'short' means having the legal obligation to deliver something at the expiration of the contract, although the holder of the short position may alternately buy back the contract prior to expiration instead of making delivery. Short futures transactions are often used by producers of a commodity to fix the future price of goods they have not yet produced. Shorting a futures contract is sometimes also used by those holding the underlying asset (i.e. those with a long position) as a temporary hedge against price declines. Shorting futures may also be used for speculative trades, in which case the investor is looking to profit from any decline in the price of the futures contract prior to expiration.
An investor can also purchase a put option, giving that investor the right (but not the obligation) to sell the underlying asset (such as shares of stock) at a fixed price. In the event of a market decline, the option holder may exercise these put options, obliging the counterparty to buy the underlying asset at the agreed upon (or "strike") price, which would then be higher than the current quoted spot price of the asset.
Currency
Selling short on the currency markets is different from selling short on the stock markets. Currencies are traded in pairs, each currency being priced in terms of another so there is no possibility for any single currency to get to zero. In this way selling short on the currency markets is identical to selling long on stocks.
Novice traders or stock traders can be confused from failure to recognize and understand this point: a contract is always long in terms of one medium and short another.
When the exchange rate has changed the trader buys the first currency again; this time he gets more of it, and pay back the loan. Since he got more money than he had borrowed initially, he earns money. Of course, the reverse can also occur.
An example of this is as follows: Let us say a trader wants to trade with the dollar and the Indian rupee currencies. Assume that the current market rate is $1=Rs.50 and the trader borrows Rs.100. With this, he buys $2. If the next day, the conversion rate becomes $1=Rs.51, then the trader sells his $2 and gets Rs.102. He returns Rs.100 and keeps the Rs.2 profit.
One may also take a short position in a currency using futures or options; the preceding method is used to bet on the spot price, which is more directly analogous to selling a stock short.
Risk
Note: this section doesn't apply to currency markets
It is important to note that buying shares (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 rather than as an investment in its own right.
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.
The risk of large potential losses through short selling inspired financier Daniel Drew to warn:
"He who sells what isn't his'n, must buy it back or go to pris'n"
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. When the price of a stock rises significantly, some people who are short the stock will cover their positions to limit their losses (this may occur in an automated way if the short sellers had stop-loss orders in place with their brokers); others may be forced to close their position to meet a margin call; others may be forced to cover, subject to the terms under which they borrowed the stock, if the person who lent the stock wishes to sell and take a profit. 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. 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.
On occasion, a short squeeze is deliberately induced. This can happen when a large investor (a company or a wealthy individual) notices significant short positions, and buys many shares, with the intent of selling the position at a profit to the short sellers who will be panicked by the initial uptick.
Short sellers have to deliver the securities to their broker eventually. At that point they will need money to buy them, so there is a credit risk for the broker. To reduce this, the short seller has to keep a margin with the broker.
Finally, short sellers must remember that they are betting against the overall upward direction of the market. This, combined with interest costs, can make it unattractive to keep a short position open for a long duration.
Strategies
Speculation
A seller intentionally takes on directional risk in the belief that the value of the shorted asset will fall.
Hedging
- Further information: Hedge fund
Short selling often represents a means of minimizing the risk from a more complex set of transactions. Examples of this are:
- a farmer who has just planted his wheat wants to lock in the price at which he can sell after the harvest. He would take a short position in wheat futures.
- a market maker in corporate bonds is constantly trading bonds when clients want to buy or sell. This can create substantial bond positions. The largest risk is that interest rates overall move. The trader can hedge this risk by selling government bonds short against his long positions in corporate bonds. In this way, the risk that remains is credit risk of the corporate bonds.
Arbitrage
- Further information: Arbitrage
A short seller may be trying to benefit from market inefficiencies arising from the mispricing of certain products. Examples of this are
- an arbitrageur who goes long futures contracts on a US Treasury security, and sells short the underlying US Treasury security.
Against the box
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 (and possibly incur taxes if said position has appreciated). Whether prices increase or decrease, the short position balances the long position and the profits are locked in (less brokerage fees and short financing costs).
U.S. investors considering entering into a "short against the box" transaction should be aware of the tax consequences of this transaction. Unless certain conditions are met, the IRS deems a "short against the box" position to be a "constructive sale" of the long position, which is a taxable event. These conditions include a requirement that the short position be closed out within 30 days of the end of the year and that the investor must hold their long position, without entering into any hedging strategies, for a minimum of 60 days after the short position has been closed.
Opinions
Short sellers are widely regarded with suspicion because, in the views of 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.[4] Some businesses campaign against short sellers who target them, sometimes resulting in litigation.
Advocates of short sellers say that the practice is an essential part of the price discovery mechanism. They state that short-seller 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 emerged.
Such noted investors as Seth Klarman and Warren Buffett have said that short sellers help the market. Klarman argued that short sellers are a useful counterweight to the widespread bullishness on Wall Street,[5] while Buffett believes that short sellers are useful in uncovering fraudulent accounting and other problems at companies.[6]
The regulatory response
The uptick rule provides 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, U.S. 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. In June 2007, the SEC eliminated the uptick rule.
In the U.S., Initial Public Offerings (IPOs) cannot be sold short for a month after they start trading. This mechanism is in place to ensure a degree of price stability during a company's initial trading period. However, some penny stock brokerages (also known as bucket shops) have used the lack of short selling during this month to pump and dump thinly traded IPOs. Canada and other countries do allow selling IPOs (including U.S. IPOs) short.
Regulation SHO was the SECs first update to short selling restrictions since 1938. It established "locate" and "close-out" requirements for broker-dealers, in an effort to curb naked short selling. Compliance with the regulation began on January 3, 2005.[7]
In October 2003, the SEC 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.[1]
"Short and distort"
A "Short and Distort" scam involves short selling a stock while smearing a company with false rumors to drive the stock's price down.
The term was coined in the period immediately after the collapse of Enron, as a parallel to pump and dump. In a pump and dump, untrue or exaggerated promotion, creating artificial demand, is carried out to sell stock, previously purchased cheaply, at the inflated price. In "short and distort," a stock is sold short, to profit from declines in share prices. Untrue or exaggerated negative information (creating artificial selling motivation) is disseminated to allow fraudulent profits to occur. [8]
Because they've lost money recently on bubble stocks and accounting scandals, investors are more receptive to believing there's more bad news ahead. Short-and-distort tactics work best with smaller companies whose stock prices are more volatile. Companies hit by this scam say it's difficult to fight back, given the speed at which rumors can be disseminated online.[9]
In 2006, the Attorney General of Connecticut Richard Blumenthal told the SEC that there was "mounting evidence that some traders--including hedge funds--engage in the practice 'short and distort,' " in comments to the SEC.[10] In Senate testimony, he said such problems "may be the aberrant exception, a small proportion, not the rule."[11]
See also
- Repurchase agreement
- Securities lending
- Short ratio
- Socially responsible investing
- Manuel P. Asensio
- Joseph Parnes
- Long (finance)
- Straddle
External links and sources
- Short Selling Introduction
- Short Interest: What it tells us
- SEC Discussion of Naked Short Selling
- '"Financial Interest Disclosures Can Protect Markets From 'Short & Distort' Manipulators", Alex J. Pollock, June 6 2006, Washington Legal Foundation
- Don't Sell Short Selling Short
- Paulos, John Allen (2003). "Chapter 2, Subheading 'Pump and Dump', 'Short and Distort'", A Mathematician Plays the Stock Market. Basic Books. ISBN 978-0465054800.
- Surowiecki, James (August 12, 2002). Short and Distort. The New Yorker.
References
- ^ a b Understanding Short Selling - A Primer
- ^ BBC News - Hedge funds cash in on Rock's demise
- ^ ORDER SUSPENDING THE OPERATION OF SHORT SALE PRICE PROVISIONS FOR DESIGNATED SECURITIES AND TIME PERIODS. Securities And Exchange Commission. Retrieved on 2007-01-06.
- ^ Short Sale Constraints And Stock Returns by C.M Jones and O.A. Lamont
- ^ Margin of safety (1991), by Seth Klarman. ISBN 0-88730-510-5
- ^ 2006 Berkshire Hathaway Annual Meeting Q&A with Warren Buffett
- ^ U.S. SEC (April 11, 2005). Division of Market Regulation: Key Points About Regulation SHO.
- ^ New Market Trend: Short, Distort," Wired magazine, June 3, 2002
- ^ Wired magazine, supra.
- ^ Liz Moyer, Forbes (September 25,2006). Wall Street Disses Regs.
- ^ Connecticut AG testimony on hedge fund short selling
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