Selling Short

Most investors make money by buying a security at a low price, then selling it later for a higher price. Owning a security is having a long position in that security. Selling short is a way to profit when the securities decline in price, by borrowing the securities, selling it, then hoping to be able to buy it back later at a lower price to replace the securities borrowed. However, if the securities pay a dividend or interest before the short is covered, then the short seller must pay those amounts to the lender of the securities.

In order to borrow the securities to sell short, the broker may lend out securities from the brokerage's own inventory, or from that of another brokerage, or he may lend out securities held in the margin accounts of other investors. If the broker is unable to borrow the securities, as sometimes happens with illiquid securities, for instance, then the security cannot be sold short.

A broker can lend out securities from the margin accounts of other investors, because the standard margin agreement allows it. When an investor opens a margin account at a brokerage, any securities bought for the account are held in the street name, the name of the brokerage for the beneficial interest of the investor and as collateral for any borrowing. The standard margin agreement allows the broker to lend out the securities held in its margin accounts to short sellers. And since margin is required to sell short, the investor must have a margin account.

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Example 1 — Profits and Losses from Selling Short.

An investor borrows 100 shares of XYZ stock that is currently trading at $35 per share and pays a 4% dividend, and sells it. Assume that the stock paid a dividend of $1.40 per share before the short seller covered his short. This puts $3,500 in the short seller's margin account, of which $140 will eventually be deducted to pay for the dividend. If the price subsequently declines to $30, the investor can buy it back for $3,000 to return the borrowed shares, thus covering the short position, and netting $500 - $140 = $360 from the trade. If, however, the price of GM stock rises to $40, then the short seller will have to buy back the stock for $4,000, resulting in a net loss of $500 + $140 = $640. Brokerage commissions must also be subtracted from any profit or added to any loss. Note that for the same price movement of the stock, the loss from an unfavorable move is much greater than the profit gained from a favorable move.

Before 1998, many investors sold short stocks that they actually owned—selling short against the box—as a means to protect capital gains, or to convert a short-term gain into a long-term gain, which has a lower tax rate. However, this method has been rendered ineffective by the Taxpayer Relief Act of 1997. Any short sale against the box after June 8, 1997, is considered a constructive sale by the IRS, and is subject to a capital gains tax in the year of the sale.

A large investor may also sell short against the box to prevent the disclosure of ownership in the security.

Calculating the Rate of Return for a Short Sale

Although a short seller receives money from a short sale, the short seller must post an additional margin requirement that is typically equal to ½ of the value of the shorted stock. So if $10,000 of stock is shorted, then the short seller must have at least $5,000 in his account to cover his liability for the short sale. Hence, right after the short sale, the short seller would have at least a total of $15,000 in cash or equity in his account.

The rate of return for a short sale is calculated by the following formula:

Rate of Return for a Short Sale Formula
Short Rate of Return =Stock Sale Price - Dividends Paid - Stock Purchase Price
Initial Margin Requirement

So the rate of return in Example 1 for the profitable investment is ($3,500 - $140 - $3,000) / $1,750 = $360 / $1,750 = 20.57%, while the return of return for the investment loss = $640 / $1,750 = 36.57%.

Margin

Short sales can only be made from a margin account. Typically, a margin account allows the account holder to borrow up to 50% of the equity in the account for the purchase of new securities. There is also a maintenance requirement that is typically 30% of the equity. If the value of the equity drops below 30% of the total amount, then the broker issues a margin call. The investor either has to send more cash or other equity, or the broker will sell enough of the securities, to increase the total equity back to 50%. Thus, if the investor initially deposits $5,000 into a new margin account, he can buy up to $10,000 worth of stocks. If the value of those stocks subsequently declines to below $7,000, then the investor will be subject to a margin call, because $2,000 is what remains of the investor's equity, which is less than 30% of the total amount in the account. He will have to deposit another $1,500 to bring the equity to back to 50%.

The margin and the margin maintenance requirement are specified by Regulation T, enacted by the Federal Reserve Board. Currently Regulation T requires an initial deposit of $2,000 or more for a margin account, and, initially, 50% or more in cash or eligible securities as security for any borrowing to buy securities. As applied to a short sale, the investor must have at least 50% of the short-sale proceeds in equity. Brokers may establish more stringent requirements.

In a short sale, money is deposited into the short seller's account, but this money is borrowed, because they are the proceeds of borrowed shares that were sold, and therefore, this money earns no interest for the account holder. Thus, instead of securities, the short seller has borrowed money in his account, which is subject to the same margin restrictions as buying stock. The amount of short sales proceeds doesn't change after the sale, but the price of the borrowed security does, and margin requirements are tied to the price of the shorted security, not the money in the account, because, eventually, the shorted securities will have to be bought to replace the borrowed shares. Therefore, the current margin of the account is dependent on the current market price of the shorted security because the short seller has a legal obligation to buy back and return the securities that were borrowed.

The equity of a short account is equal to the amount on deposit minus the current value of the shorted security:

Equity = Account Value - Market Value of Shorted Security

The short seller also has an obligation to pay any dividends to the shareholder of the borrowed stocks, and since neither the lender nor the short seller owns the shorted stock, neither receive the dividends paid by the corporation, but the lender is still entitled to dividend payments, so the short seller must pay what is known as substitute payments in lieu of dividends to the stock lender. The broker pays this automatically from the short seller's account, which decreases the amount on deposit, and therefore, the short seller's equity and margin.

Example — Calculating the Equity of a Short Account

If you deposit $5,000 and sell 1,000 shares of XYZ stock short for $10 per share, then there is $15,000 on deposit in your account, but your equity is still $15,000 - $10,000 = $5,000, which is, of course, what you initially deposited.

If XYZ price rises to $12 per share, then your equity = $15,000 - $12,000 = $3,000.

If XYZ price drops to $8 per share, then your equity = $15,000 - $8,000 = $7,000.

To calculate margin, just divide equity by the market value of the shorted security:

Calculating the Current Margin of a Short Account
Margin =Equity
CMV

CMV = Current Market Value of Shorted Security

Math Note: Multiply fraction by 100 to get a percentage.

Example—Calculating the Current Margin and Current Equity of a Short Sale.

You open a margin account and deposit $5,000. You sell short 1,000 shares XYZ stock for $10 per share. The proceeds of the sale, $10,000, is deposited in your account. There is now $15,000 in your account. However, you still only have $5,000 of equity in your account, because the $10,000 of short-sale proceeds is from borrowed securities.

Scenario 1 — The stock price declines to $6 per share, so the 1,000 shares that you sold short is currently worth $6,000. Thus:

Thus, this short sale would be profitable if you bought back the shares now to cover your short, for a net profit of $4,000 minus brokerage commissions and any dividends that had to be paid while the stock was borrowed.

Scenario 2 — The stock price rises to $12.00 per share, thus it will cost you $12,000 to buy back the shares now.

Because your current margin is now less than 30%, you will be subjected to a margin call. If you decide to buy back the shares now to cover your short, your net loss will be $2,000 plus brokerage commissions and any dividends that had to be paid while the stock was borrowed.

Determining the Value of Shorted Securities That Will Elicit a Margin Call

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The formula for calculating the value of securities that will elicit a margin call for shorted stock can be derived from the formula for calculating margin:

  1. Margin = (Account Value - Value of Shorted Securities) / Value of Shorted Securities
  2. Let m = margin ratio; a = account value; and v = value of shorted securities.
  3. m = (a - v) / v
  4. m * v = a - v Multiply both sides by v.
  5. v + m * v = a Add v to both sides.
  6. v (1 + m) = a Factor out v from the left side.
  7. v = a / (1 + m) Divide both sides by 1 + m.
  8. Value of Shorted Securities = Account Value / (1 + Margin)

Thus, the short account value that will trigger a margin call can be calculated with the following formula:

Calculating the Margin Call Account Value of a Shorted Security
Margin Call Account Value =Account Value
1 + MMR

MMR = Margin Maintenance Requirement (which is usually .3 = 30%).

Price per Share = Margin Call Account Value/Number of Shares

Example — Calculating the Margin Call Price of a Shorted Security

Using the above example, what market price of the shorted security will trigger a margin call?

The total amount on deposit in the account is $15,000 and the margin maintenance requirement is 30%. Therefore, the margin call value = 15,000/(1 + .3) = 15,000/1.3 = $11,538.46. This is equal to a price per share of $11,538/1,000 = $11.54 (rounded) per share. So a margin call will be triggered when the price of the shorted security rises to $11.54.

To verify, we substitute $11,538.46 into the margin formula above, and find that (15,000 - 11,538.46)/11,538.46 = 0.30 = 30%, the margin maintenance requirement. Note that if any dividends were paid out, this would have to be subtracted from the amount on deposit.

Restrictions on Selling Short — the Short Sale Rule

Selling securities tends to decrease their price by increasing supply and reducing demand, so short sellers can actually drive down the price of the borrowed stock through their short sales. In the past, short sellers formed pools for this purpose.

To prevent this, the Securities and Exchange Commission enacted the short-sale rule, alternately known as the plus tick or uptick rule, which requires that a stock can only be sold short if the last transaction of the stock was a uptick, or an increase in price, or if there was no price change in the last transaction, but the previous change in price was an uptick, which is known as the zero-plus tick rule or the zero-uptick rule.

This rule does not generally apply to derivative securities—securities whose prices depend on another security or basket of securities, such as exchange-traded funds. Although the current prices of derivatives are dependent on the instantaneous market supply and demand, just like any other security, the price of derivatives is determined by the prices of the derived securities. If the price of the derivative fell too far below the price of the underlying asset, then investors would see it as a bargain and buy it, increasing the demand, and, thus, its price. In certain cases, arbitrageurs can take advantage of any significant differential in prices, which, in effect, closes the price gap between the securities.

A company insider also may not sell short the company's stock, which makes sense, since allowing this would allow company insiders to steal money from investors of the company, by selling the stock short, then issuing bad news to drive down the price of the stock.

News Update - Short Sale Uptick Rule Eliminated

On June 13, 2007, the Commission voted to remove the short sale uptick rule test of Rule 10a-1: http://www.sec.gov/news/digest/2007/dig062807.txt

Naked Short Selling

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Naked short selling is selling a stock short without first borrowing it. This often results from a failure to deliver (aka fail) the certificates to the buyer of the stock at settlement, which is the result of institutional failure to effect the transfer. However, market makers are permitted to do some naked short selling to increase the liquidity of the market when it is difficult to borrow the stock quickly enough to satisfy market demand. However, naked short selling is illegal as a means to drive down stock prices in order to buy at a better price.

Risks of Selling Short

There are risks to selling short. The most obvious risk is that the stock price can rise and continue to rise. The price of a stock can rise much higher than it can fall, and, therefore, the potential for losses is much greater than the potential for profits.

Another risk is that the short seller may be forced to buy back the stock, because the shares sold short were borrowed, and the lender may request those shares back at any time. Usually the broker can obtain other shares from other investors, but if the shares are scarce, such as occurs with securities with little float, then the broker may have no choice but to buy back the shares at the current market price. Sometimes, investors who are long in a stock with a large short interest will buy more of the stock, or ask their broker to deliver the actual stock certificates to them, in the hope of forcing the short sellers to cover their position by buying the stock back—this is called a short squeeze.

Short Interest — Supposed Indicator of Market Sentiments

Because investors sell short so they can profit by expected price declines in the shorted securities, or they want to hedge their positions because they at least think a price decline is a good possibility, many investors look at the total short interest as a good indicator of market sentiments.

Short interest is the total number of shares that have been sold short, but not repurchased yet, to cover the short positions on an exchange. The New York Stock Exchange (NYSE), American Stock Exchange (AMEX), and the NASDAQ release the short interest volume for their exchanges by the middle of the month, and is reported in The Wall Street Journal about a week after that.

The short-sale ratio (also, short ratio), is the total number of shares shorted, but not covered, divided by the average daily volume of all shares traded on the exchange.

Short Ratio =Number of Shares Shorted, but Not Covered
Average Daily Volume of All Shares Traded on Exchange

Note that while the numerator of the short ratio increases with short interest, the denominator, the average daily volume for that month, is not related to the short interest, and, therefore, the short ratio may actually decline when the short interest increases, which would occur when the average daily volume increases more than the short interest—and vice versa. Note, also, that, for the same reason, the short ratio does not quantify the short interest.

Real World Example—Divergence of Short Interest and the Short-Sale Ratio

On August 22, 2006, The Wall Street Journal reported that, for the month ending August 15, 2006, the short interest on the NYSE increased from the mid-July total of 9,298,283,040 shares to 9,638,209,066 shares—an increase of about 3.7%—but the short ratio actually decreased from 6.1% to 5.9% for the same month.

Some investors, however, consider a large short interest to be a bullish sign, because the short sellers will have to purchase the shorted security at some point, which will tend to increase its price. This is sometimes called the short interest theory, or the cushion theory. Technical analysts consider a short position that is twice the average daily trading volume to be a very bullish sign, and a good possibility for a short squeeze, which results when short sellers buy to cover their position, raising the stock price, which, in turn, causes more short sellers to cover their positions, thereby raising the stock price even more.

There are more specialized short-interest ratios that some investors consider. The odd-lot short-sale ratio (aka odd-lot selling indicator) is the total of odd-lot short sales divided by the total odd-lot sales.

Odd-Lot Short-Sale Ratio =Total Odd-Lot Short Sales
Total Odd-Lot Sales

This supposed prognosticator is based on the odd-lot theory, which is based on the supposition that people who buy and sell odd lots (less than 100 shares or a round lot) are novice investors, and are acting in direct opposition to true market conditions. Thus, when odd-lot selling is high, then the market has bottomed out, and it's time to buy, and vice versa. There is no real evidence that the odd-lot theory is true, but even if it is, it may be because investors believe that it is true, and act accordingly.

The member short-sale ratio, using similar, specious reasoning, is supposed to be the true market indicator, and there may be a grain of truth to this. After all, if anyone would know the market, it would be the members of the NYSE who—specialists, floor traders, and off-the-floor traders—specialize in the particular securities that they sell short. The member short-sale ratio is the total shares sold short in the accounts of the NYSE members in 1 week divided by the total short sales outstanding in the same week.

Member Short-Sale Ratio =Total Shares Shorted by NYSE Members in 1 Week
Total Short Sales Outstanding in Same Week

The member short-sale ratio is published weekly in The Wall Street Journal and Barron's.

The specialist's short-sale ratio is computed in the same way as the member short-sale ratio, but only includes the accounts of the specialists on the NYSE.

Specialist Short-Sale Ratio =Total Shares Shorted by NYSE Specialists in 1 Week
Total Short Sales Outstanding in Same Week

Some short sales are made to provide an orderly market in the securities assigned to the specialist—one of their duties—but many investors, especially technical investors, use this as a prognosticator of the markets.