Short (finance) Totally Explained

Everything about Short Finance totally explained

In finance, short selling or "shorting" is the practice of selling securities the seller doesn't then own, in the hope of repurchasing them later at a lower price. This is done in an attempt to profit from an expected decline in price of a security, such as a stock or a bond, in contrast to the ordinary investment practice, where an investor "goes long," purchasing a security in the hope the price will rise.
The term "short selling" or "being short" is often also 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.

Concept

To profit from the stock price going down, short sellers can borrow a security and sell it, expecting that it'll 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. The lender of the shares doesn't lose the right to sell the shares.
   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'll 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.
   In the U.S., in order to sell stocks short, the seller must arrange for a broker-dealer to confirm that it's able to make delivery of the shorted securities. This is referred to as a "locate," and it's 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 can't 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 hasn't 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 won't 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.

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 losses as well. 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. Because a short is the opposite of a long (normal) transaction, everything is the mirror opposite compared to the typical trade: the profit is limited but the loss is unlimited. Since the stock can't be repurchased at a price lower than zero, the maximun gain is the difference between the current stock price and zero. However, because there's no ceiling on how much the stock price can go up (thereby costing short transactions money in order to buy the stocks back), an investor can theoretically lose an arbitrarily large amount of money if a stock continues to rise. Also, in actual practice, as the price of XYZ Company began to rise, the short seller would eventually receive a margin call from the brokerage, demanding that the short seller either cover his short position or provide additional cash in order to meet the margin requirement for XYZ Company stock.

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 the United States 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; this was known as the uptick rule, and was in effect until 2007. President Herbert Hoover condemned short sellers and even J. Edgar Hoover said he'd 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). 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.
   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 irrationally 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.

Mechanism

Short selling stock consists of the following:

An investor borrows shares. (If required by law, the investor first ensures that cash or equity is on deposit with his brokerage firm as collateral for the initial short margin requirement.) Some short sellers, mainly firms and friendly hedge funds participate in what is "naked short" selling, where the shorted shares are not borrowed or delivered.
In either case the investor sells the shares and the proceeds are credited to his broker's account at the firm upon which the firm can earn interest. Generally the short seller doesn't earn interest on the short proceeds.
The investor may "close" the position by buying back the shares (called covering). If the price drops, he makes a profit. If the stock advances he takes a loss. If the stock drops substantially, then the profit can be taken without closing the position and no taxable event occurs.
Finally, the investor may return the shares to the lender or stay short indefinitely.

Securities lending

When a security is sold, the seller is contractually obliged to deliver it to the buyer. If a seller sells a security short without owning it first, the seller needs to borrow the security from a third party to fulfill its obligation. Otherwise, the seller will "fail to deliver," the transaction won't settle, and the seller is subject to a claim from its counterparty. Certain large holders of securities, such as a custodian or investment management firm, often lend out these securities to gain extra income, a process known as 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 can't be used as collateral for margin buying.

Sources of short interest data

Time delayed short interest data is available in a number of countries, including the US, the UK, Hong Kong and Spain. Some market participants (like Data Explorers Limited) believe that stock lending data provides a good proxy for short interest levels. The amount of stocks being shorted on a global basis has increased in recent years for various structural reasons (for example the growth of 130/30 type strategies). News on short positions is still sparse but various blogs including Seeking Alpha, Marketbeat, Short Stories and Shortsqueeze provide ad hoc reporting.

Major lenders

State Street Corporation (Boston)

JP Morgan Chase (New York)

Northern Trust (Chicago)

Citibank (New York)

Mellon Bank Corp. (Pittsburgh)

Bank of New York (New York)

The Bank of New York and Mellon Bank Corp. formally merged in July of 2007, creating the Bank of New York Mellon Corporation.
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 don't have this restriction, as this would seriously restrict liquidity.
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 the holder of the short position (for example, the price of the security begins to rise), money will be removed from the holder's cash balance and moved to his or her margin balance. If short shares continue to rise in price, and the holder doesn't have sufficient funds in the cash account to cover the position, the holder will begin to borrow on margin for this purpose, thereby accruing margin interest charges. These are computed and charged just as for any other margin debit.
   When a security's ex-dividend date passes, the dividend is deducted from the shortholder's account and paid to the person from whom the stock was borrowed.
   For some brokers, the short seller may not earn interest on the proceeds of the short sale or use it to reduce outstanding margin debt. These brokers may not pass this benefit on to the retail client unless the client is very large. This means if an individual short-selling $1000 of stock will lose the interest to be earned on the $1000 cash balance in his or her account.
The Dividend
If the company distributes the dividend, the short seller is also "short the dividend". This is because he borrowed the stock shares and sold them to another investor. The investor he sold them to expects a dividend. The investor he borrowed the shares from expects a dividend also. This demonstrates that the "borrowing" isn't really borrowing in the usual sense because the original shareholder has the use of the stock share, as demonstrated by the fact he still gets the dividend. (If John borrows Jim's shovel, Jim doesn't have use of his shovel anymore). Not so with the type of "borrowing" going on with stocks borrowed in order to short them.
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've not yet produced. Shorting a futures contract is sometimes also used by those holding the underlying asset (for example 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's 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'd 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 to Rs.50 and the trader borrows Rs.100. With this, he buys $2. If the next day, the conversion rate becomes $1 to 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's 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 that'll need money to buy them, so there's 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're going 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
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
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 buys 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're profiting from the misfortune of others. 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. Financial researchers at Duke University have provided statistically significant support for the assertion that short interest is an indicator of poor future stock performance and that short sellers exploit market mistakes about firm's fundamentals.
   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, while Buffett believes that short sellers are useful in uncovering fraudulent accounting and other problems at companies.
The regulatory response
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.
   In the U.S., Initial Public Offerings (IPOs) can't 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.
"Short and distort"
A "Short and Distort" scam, also called a bear raid, 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.
   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. In Senate testimony, he said such problems "may be the aberrant exception, a small proportion, not the rule."
   In March 2008 the United Kingdom's HBOS was thrown into turmoil due to rumours of a liquidity crisis (External Link), causing a serious share price slump and profiteering by short sellers.
   During the takeover of Bear, Stearns & Co. by J.P. Morgan Chase in March of 2008, reports swirled that shorts were spreading rumors to drive down Bear, Stearns' share price. Sen. Christopher Dodd, D-Conn., said this was more than rumors and said, "This is about collusion."

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