Short Selling

You are probably familiar with the concept of “buy low, sell high.” If you buy a stock for $30 and sell it for $40, you pocket the $10 difference as a profit. In stock market lingo, if you buy a stock, you are “long” the stock. Traders who are long stock hope to sell it at a later time for a higher price. A trader who is long stock is “bullish” on the stock, which is just another stock market term describing the upward expected price movement of the stock. A bull attacks by lowering its horns and then raising them high, which is what long stock traders hope will happen to the price of the stock – move from low to high.

We can also reverse the “buy low, sell high” equation and “sell high, buy low” and effectively do the same thing. In order to do this, you must first sell stock and then buy it back at a later time. In order for this to work though, you cannot already own the stock. If you already own the stock and then sell it, you’re out of the position. This means that, in order to sell first, you must sell stock that you do not already own. How can you sell something you don’t own? You must borrow the shares.

Once you sell the borrowed shares, you will collect the cash from the sale but then have the obligation to buy the shares at a later time to return to the owner. Hopefully you will be able to buy them back at a lower price thus pocketing the difference.

If you sell a stock for $40 and buy it back later for $30, you will pocket the $10 difference as a profit. You have effectively bought low and sold high but just in the reverse order. Traders who sell the stock first are “short” the stock. If you short a stock, you are “bearish” on the stock, which is a stock market term describing the downward expected price movement on a stock. Bears attack by lowering their paws from high to low, which is exactly what short stock traders hope will happen to the price of the stock – move from high to low.

As a recap, if you are bullish on a stock (think its price will rise) you’d “go long” the stock. If you are bearish on a stock (think its price will fall), you’d “go short,” which is also called “selling short,” or just “shorting.”

If you choose to only buy stock, then you can only make money on stocks whose prices rise. But if you also add short sales to your arsenal, then you can profit from stocks whose prices rise or fall.

How Does a Short Sale Work?

In order to short a stock, you must borrow shares from your broker. While this may sound like a complicated process, it actually takes a matter of seconds. The reason is that when you sign a margin agreement, you are giving your broker the right to hypothecate stock, which is just a fancy term for loaning. So for example, if you have shares of Microsoft in your margin account, it’s possible that the broker may loan those shares to another trader to short. But don’t be worried, your account will always show those shares available for you to sell even though they technically may not be there. The entire process will be completely transparent to you. As far as you’ll know, the shares are always in your account. If you decide to sell them, the broker will get the shares from yet another account, which will allow you to place the sale.

If this is the first time you’ve heard about the process of shorting, it may leave you feeling a little uneasy. The idea of stock moving from your account to someone else’s without you even knowing about it sounds fishy. But if you think about it, you already do this everyday – whenever you deposit or withdraw money from your bank.

If you deposit $1,000 to your account, that money is not sitting in a special box with your name on it so that only you can access it. On the contrary, it is immediately loaned to someone else even though your account will always show that the $1,000 cash sitting there. If you decide to withdraw it, your banker will get the money from yet another account and it will make no difference to you. This is exactly what happens when your broker loans your shares to others for shorting.

Once you get the shares from your broker, you simply enter an order to “sell short” those shares and then you have an obligation to buy an equivalent share amount of the same stock back at some time in the future. In most cases, you can enter a short sale online but your broker must locate the shares for first before allowing the sale to go through. Short sales can be executed with nearly the same speed and ease of buying stock. In order to short stock though, you must have a margin account.

Short Sale Example

Let’s take a look at an example of a short sale and assume you think that ABC stock will fall. You’d simply call your broker or log onto your online account and “sell short” a specific number of shares of ABC stock.

In order for that sale to go through, it must be done on an uptick, which simply means that the price you sell at must be higher than the previous price on the tape. This rule was created to prevent traders from shorting into downdrafts, which would only accelerate the downward motion. By selling on an uptick, it shows that there was some buying pressure at that time.

The uptick rule is nothing you need to watch for as the computer will automatically take care of whether the trade is on an uptick or not. Just be aware that this little technicality makes it possible to not get filled even if you place a market order. But in most cases, short sales “at market” are filled within seconds of placing the trade.

Let’s assume you sell short 100 shares of ABC, which is currently $50 per share. Your account is credited with $5,000 cash (100 shares * $50 per share. But you don’t just get the $5,000 for nothing; you must also post the 50% Reg T requirement that we talked about in the “Cash vs. Margin Accounts” course. This means you must come up with half that amount, or $2,500, of your own cash so that the total credit to your account is $7,500. Your account will also show that you are short 100 shares of ABC. This is just telling you that you owe 100 shares back to the broker at some time to replace the shares you borrowed. There is no time limit as to how long you have to buy the shares back; however, if there are adverse movements in the stock, you may be forced to close out the position early if you cannot continue to fund it.

After you short the stock, the accounting looks like this:

  Credit Balance =         $7,500

- Market Value Short = $5,000

  Equity =                      $2,500

The credit balance is the sum of the $5,000 cash you received from the short sale plus your $2,500 cash that you had to post for margin. Your equity percentage is found by dividing the equity into the market value short. In this example, your equity percent is $2,500/$5,000 = 50%.

The credit balance never changes; that is all the cash you will ever get from the sale of that stock. So how do you make money? By looking at the above equation, you can see that your equity will grow only if the market value short declines. And this is exactly what you expect to happen if you are short the stock. You are hoping to be able to buy back the stock at a cheaper price.

Let’s assume that the price of the stock does decline from $50 to $40. The market value short then falls from $5,000 to $4,000 and your equity will increase by $10 * 100 shares = $1,000 as well:

  Credit Balance =         $7,500

- Market Value Short = $4,000

  Equity =                      $3,500

You started with $2,500 equity and now have $3,500 equity for a $1,000 increase. If you buy back the shares now at $40, you will spend $4,000 out of your $7,500 credit balance and be left with $3,500.

The reason that short sales work is because you are obligated to buy back a fixed share amount – not a fixed dollar amount. This is no different than when you, for example, borrow a cup of sugar from your neighbor; you have the obligation to return a cup of sugar – not a specific dollar amount of sugar. When you shorted the 100 shares of ABC at $50, you created an obligation to return 100 shares to your broker – not an obligation to return $5,000 worth of stock. If the price of the stock drops, it becomes cheaper for you to replace the shares and you will profit from the difference in prices.

Adverse Price Movements

We said earlier that there is no time limit for you to buy back the shares. That’s true assuming that you are able to meet any maintenance calls that might occur while holding the shares short. If you cannot, your broker will require that the position be closed at a loss. For example, let’s assume you short 100 shares of ABC at $50 and post the $2,500 margin requirement as you did in the previous example:

  Credit Balance =         $7,500

- Market Value Short = $5,000

  Equity =                      $2,500

Your equity percent is $2,500/$5,000 = 50%, which is where it should be right after the trade. But now let’s assume that the stock rises to $60 per share and your broker has a 30% house requirement:

  Credit Balance =         $7,500

- Market Value Short = $6,000

  Equity =                      $1,500

Your equity percent is now $1,500/$6,000 = 25% and you have a maintenance call since you have fallen below your broker’s house requirement of 30%. You must either buy back shares, deposit money, or deposit shares of stock (it doesn’t have to be the same stock). Let’s take a look at how each of these methods will affect your account.

 

Depositing Money

If you choose to meet the maintenance call by depositing money, you will increase the credit balance and the equity dollar-for-dollar. If your broker requires a 30% minimum equity percent, we know that you should have 0.30 * $6,000 = $1,800 equity. Since your equity is only $1,500, we know you are short by $300. If you deposit $300 cash, your credit balance will increase to $7,800 and your equity will increase to $1,800:

  Credit Balance =         $7,800

- Market Value Short = $6,000

  Equity =                      $1,800

Your account is now at $1,800/$6,000 = 30% equity and you have met the maintenance call. But if the stock continues higher from here, you’ll be back in maintenance.

Buying Back Shares

Let’s go back to the original setup where your account is at 25% equity:

  Credit Balance =         $7,500

- Market Value Short = $6,000

  Equity =                      $1,500

This time, however, we will assume that you buy shares back to get out of maintenance. If you buy back shares, you will reduce the credit balance and market value short dollar-for-dollar. In other words, you’re using some of that cash to buy back shares. If you wish to get back to 30% equity, you must buy back 1/0.30 = 3.33 times as many shares. In the last section, we figured out that your account should have $1,800 equity, which means you’re $300 short. In this example, you’d therefore need to buy back 3.33 * $300 = $1,000 worth of stock. Your credit balance will be reduced to $6,500 and your market value short will be reduced to $5,000:

  Credit Balance =         $6,500

- Market Value Short = $5,000

  Equity =                      $1,500

Note that your $1,500 equity does not change; however, the percentage equity does change and you’re now at $1,500/$5,000 = 30% equity. You are out of maintenance for now.

Depositing Shares of Stock

You can also meet a maintenance call of a short position by depositing shares of stock. If you do, you increase your credit balance in a similar way as depositing cash. If you remember back to the “Cash vs. Margin Account” course, when you deposit stock to your account, you get a “cash release” to your account since you’re only required to have 50% equity in the stock. So when you deposit stock, you are, in effect, depositing cash. However, you’re not getting cash released in an equal amount as the value of the stock.

The accounting can look a little tricky when you consider long and short positions but it’s actually straightforward. All we do is add the equities of the long and short sides and then divide by the total market values. Let’s assume you deposit $2,000 worth of stock and get $1,000 released from that deposit. You’re now short $6,000 worth of stock and long $2,000 worth for a total market value of $8,000. Your equity is $1,500 on the short side and $2,000 on the long side:



Your total equity is now ($1,500 + $1,000)/($6,000+$2,000) = 31% and you are out of maintenance.

These examples are designed to show you the mechanics of how a short sale works. Fortunately, you’ll never need to calculate these figures as your broker or online information will show that to you automatically. But at least you’ll have an idea of how these numbers are found.

Why Allow Shorts Sales?

Many traders wonder why short sales are allowed. After all, there is something that doesn’t seem right about profiting from the misfortunes of a publicly traded company. There is a good reason, though, why the exchanges created short sales. It is because it makes the market more efficient. If you are a good stock picker and have a feeling that a particular company is too highly valued, you now have a great incentive to short the stock for profit. And by shorting the stock, you put a little downward pressure on the price thus helping the rest of the market discover the true value of the company.

If you were not allowed to short it, the value of the stock could possibly stay at unfair valuations for sustained periods and that is clearly not good for the market. Just as buyers can come to the rescue of a stock that is apparently oversold, short sellers come to the rescue when stocks are apparently overbought. Short selling allows all market participants a way to “cast their vote” as to the value of a security.

Short sales are popular among speculators since stocks tend to fall much faster than they rise. It may take months for a stock to rise 20% but can take seconds for it to fall that far. There is potentially a lot of money to be made for those who can correctly short stocks.

Risks in Short Selling

We found out in the earlier sections that your short position will lose money as the stock rises. Because of this, there is a potentially big risk with short selling in that there is no theoretical limit as to how high a stock’s price can rise. If you buy $5,000 worth of stock, the worst it can do is fall to zero and you’re out $5,000. But if you short $5,000 worth of stock, there is no limit as to how much you could lose since there is no maximum price for a stock.

Of course, it is unlikely that a stock will rise infinitely high in a short period of time and, in most cases, you can close out the short position before things get too out of control. However, there is a psychological danger in holding short positions. Traders despise taking for-sure losses and will often hang on hoping that the stock will fall. The higher the stock rises, the greater the loss – and the greater their belief that it now must fall, which makes them hang on longer. Here’s a true story of a trader I observed while working on an active trader team for a large brokerage firm:

America Online

In that late 90s, a trader believed that America Online (AOL) was way overvalued, as did all the analysts, at $80 per share. The articles in every financial publication stated that this stock was so far above its earnings growth that there was only one way for it to go – down. The trader shorted 1,000 shares in hopes of riding the ominous big wave down.

The stock, however, climbed higher. And then it went higher. Eventually, the trader had a huge maintenance call and was looking at a large loss if he closed the position. Rather than take the huge for-sure loss, he decided to hold on because he felt it now must really be overvalued now and will surely come down. It didn’t.

He continued to hang on after meeting numerous maintenance calls as he felt he’d more than make up for the losses once it fell. Before he knew it, the stock had doubled and was trading for $160. Rather than close out the short for a catastrophic loss he averaged into the price and shorted another 1,000 shares – and the stock climbed higher.

Then one day AOL announced a 2:1 split, which means the trader was now short 4,000 shares. That announcement propelled it to new highs. After several frustrating months of inexplicable price rises, the trader was forced to close the position. What was the cost? He nearly wiped out a one-million dollar account. So what started out to be a simple, “sure thing” short sale became an incredibly tough psychological battle between the trader’s perception of the stock’s value and the market’s valuation of it. 

The above story illustrates an important point of any successful trading strategy. That is, have some type of exit or hedging plan. Use stop orders, call options, or other ways to prevent losses from escalating. It’s very easy to let them get out of control and that is the bigger danger of shorting stocks rather than an instantaneous price rise to astronomical levels. If you short a stock, make sure you have an exit plan – and stick to it.

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