The Basics Of Short Selling

By Investopedia Staff

Short selling (also known as shorting, selling short or going short) means the sale
of a security or financial instrument that the seller has borrowed to make the short sale. The
short seller believes that the borrowed security's price will decline, enabling it to be bought
back at a lower price. The difference between the price at which the security was sold short
and the price at which it was purchased represents the short sellers profit (or loss, as the
case may be).

Winners or Villains?

Short selling is perhaps one of the most misunderstood topics in the realm of investing. In
fact, short sellers are often reviled as callous individuals who are only out for pecuniary
gain at any cost, without regard for the companies and livelihoods destroyed in the short-
selling process. The reality, however, is quite different. Far from being cynics who try to
impede people from achieving financial success or in the U.S., attaining the American
Dream short sellers enable the markets to function smoothly by providing liquidity, and
also serve as a restraining influence on investors over-exuberance.

Excessive optimism often drives stocks up to lofty levels, especially at market peaks (case
in point dotcoms and technology stocks in the late 1990s, and on a lesser scale,
commodity and energy stocks from 2003 to 2007). Short selling acts as a reality check that
prevents stocks from being bid up to ridiculous heights during such times. While shorting
is fundamentally a risky activity since it goes against the long-term upward trend of the
markets, it is especially perilous when markets are surging. Short sellers confronted with
escalating losses in a relentless bull market are painfully reminded of John Maynard
Keynes famous adage The market can stay irrational longer than you can stay solvent.

Although short selling attracts its share of unscrupulous operators who may resort to
unethical tactics which have colorful names such as short and distort or bear raid to
drive down the price of a stock, this is not very different from stock touts who use rumors
and hype in pump-and-dump schemes to drive up a stock. Short selling has arguably
gained more respectability in recent years with the involvement of hedge funds, quant funds
and other institutional investors on the short side. The eruption of two savage global bear
markets within the first decade of this millennium has also increased the willingness of
investors to learn about short selling as a tool for hedging portfolio risk.

An Example

Lets use a basic example to demonstrate the short-selling process. For starters, you would
need a margin account at a brokerage firm to short a stock, and you would have to fund this
account with a certain amount of margin. The standard margin requirement is 150%, which
means that you have to come up with 50% of the proceeds that would accrue to you from
shorting a stock. So if you want to short sell 100 shares of a stock trading at $10, you have
to put in $500 as margin in your account.

Lets say you have opened a margin account and are now looking for a suitable short-
selling candidate. You decide that Conundrum Co. (fictional company) is poised for a
substantial decline, and decide to short 100 shares at $50 per share. Here is how the short
sale process works:

1. You place the short sale order through your online brokerage account or financial
advisor. Note that you have to declare the short sale as such, since an undeclared
short sale amounts to a violation of securities laws.

2. Your broker will attempt to borrow the shares from a number of sources the
brokerage's inventory, from the margin accounts of one of its clients or from
another broker-dealer. Regulation SHO released by the SEC in 2005 requires a
broker-dealer to have reasonable grounds to believe that the security can be
borrowed (so that it can be delivered to the buyer on the date that delivery is due)
before effecting a short sale in any security; this is known as the locate
requirement.

3. Once the shares have been borrowed or located by the broker-dealer, they will be
sold in the market and the proceeds deposited in your margin account.

Your margin account now has $7,500 in it; $5,000 from the short sale of 100 shares of
Conundrum at $50, plus $2,500 (i.e. 50% of $5,000) as your margin deposit.

Lets say that after a month, Conundrum is trading at $40. You therefore buy back the 100
Conundrum shares that were sold short at $40, for an outlay of $4,000. Your gross profit
(ignoring costs and commissions for simplicity) is therefore $1,000 (i.e. $5,000 - $4,000).

On the other hand, suppose Conundrum does not decline as you had expected but instead
surges to $70. Your loss in this case is $2,000 (i.e. $5,000 - $7,000).

A short sale can be regarded as the mirror image of going long, or buying a stock. In the
above example, the other side of your short sale transaction would have been taken by a
buyer of Conundrum Co. So your short position of 100 shares in the company is offset by
the buyers long position of 100 shares. The stock buyer, of course, has a risk-reward
payoff that is the polar opposite of the short sellers payoff. In the first scenario, while the
short seller has a profit of $1,000 from a decline in the stock, the stock buyer has a loss of
the same amount. In the second scenario where the stock advances, the short seller has a
loss of $2,000, which is equal to the gain recorded by the buyer.

Typical Short Sellers

 Hedge funds are one of the most active entities involved in shorting activity. Most
hedge funds try to hedge market risk by selling short stocks or sectors that they
consider overvalued.
Sophisticated investors are also involved in short selling, either to hedge market risk
or simply for speculation.
Speculators account for a significant share of short activity.
Day traders are another key segment of the short side. Short selling is ideal for very
short-term traders who have the wherewithal to keep a close eye on their trading
positions, as well as the trading experience to make quick trading decisions.

Short-Sale Regulations

Short selling was synonymous with the uptick rule for almost 70 years in the U.S.
Implemented by the SEC in 1938, the rule required every short sale transaction to be
entered into at a price that was higher than the previous traded price, i.e. on an uptick. The
rule was designed to prevent short sellers from exacerbating the downward momentum in a
stock when it is already declining. The uptick rule was repealed by the SEC in July 2007; a
number of market experts believe this repeal contributed to the ferocious bear market and
market volatility of 2008-09. In 2010, the SEC adopted an alternative uptick rule that
restricts short selling when a stock has dropped at least 10% in one day.

In January 2005, the SEC implemented Regulation SHO, which updated short-sale
regulations that had been essentially unchanged since 1938. Regulation SHO specifically
sought to curb naked short selling (in which the seller does not borrow or arrange to
borrow the shorted security), which had been rampant in the 2000-02 bear market, by
imposing locate and close-out requirements for short sales.

Risks and Rewards

Short selling involves a number of risks, including the following:

Skewed risk-reward payoff Unlike a long position in a security, where the loss is
limited to the amount invested in the security and the potential profit is boundless
(in theory at least), a short sale carries the theoretical risk of infinite loss, while the
maximum gain which would occur if the stock drops to zero is limited.
Shorting is expensive Short selling involves a number of costs over and above
trading commissions. A significant cost is associated with borrowing shares to
short, in addition to interest that is normally payable on a margin account. The short
seller is also on the hook for dividend payments made by the stock that has been
shorted.
Going against the grain As noted earlier, short selling goes against the
entrenched upward trend of the markets.
Timing is everything The timing of the short sale is critical, since initiating a
short sale at the wrong time can be a recipe for disaster.
Regulatory and other risks Regulators occasionally impose bans on short sales
because of market conditions; this may trigger a spike in the markets, forcing the
short seller to cover positions at a big loss. Stocks that are heavily shorted also have
 a risk of buy in," which refers to the closing out of a short position by a broker-
dealer if the stock is very hard to borrow and its lenders are demanding it back.
Strict trading discipline required: The plethora of risks associated with short selling
means that it is only suitable for traders and investors who have the trading
discipline required to cut their losses when required. Holding on to an unprofitable
short position in the hope that it will come back is not a viable strategy. Short
selling requires constant position monitoring and adherence to tight stop losses.

Given these risks, why bother to short? Because stocks and markets often decline much
faster than they rise. For example, the S&P 500 doubled over a five-year period from 2002
to 2007, but then plunged 55% in less than 18 months, from October 2007 to March 2009.
Astute investors who were short the market during this plunge made windfall profits from
their short positions.

Conclusion

Short selling is a relatively advanced strategy best suited for sophisticated investors or
traders who are familiar with the risks of shorting and the regulations involved. The
average investor may be better served by using put options to hedge downside risk or to
speculate on a decline because of the limited risk involved. But for those who know how to
use it effectively, short selling can be a potent weapon in ones investing arsenal.