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1.
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Definition
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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. 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.
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2.
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Examples, Types, or
Variations
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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.
Naked
short sale: 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.
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3.
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Formula
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Short
selling stock consists of the following:
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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.)
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The investor sells them and the proceeds are credited to his
account at the brokerage firm.
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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.
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The investor finally returns the shares to the lender.
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4.
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Related Terms
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Short Interest Ratio
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Short Interest Theory
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Borrowed Stock
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Hedged Tender
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Short Covering
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Lending at a Rate
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Short Sale Ratio
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Securities Loan
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Selling Short Against the Box
-
Bear
Trap
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5.
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As
Used in the Hedge Fund World
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It should be
noted that short selling by hedge funds frequently represents
only one leg of a more complex set of transactions which fall
into a broad range of investment strategies.
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6.
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Applications
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7.
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Misused & Abused
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Short selling has been a target of ire since at least the 17th
century when England banned it outright. Short sellers are
widely regarded with suspicion because, to many people, they are
profiting from the misfortune of others.
The term "short" was in use from at least the mid-19th 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
sharp
downturn.
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
1997).
It is important to note that buying shares and then selling them
(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.
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8.
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Additional Sources of Information
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Books
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News
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Scholarly Papers
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Back to Terms
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