Securities: Short Selling in the Stock Market

Short Selling: A Strategy to Profit from Stock Price Decline

Introduction

Short selling is a unique investment strategy that allows investors to profit from a decline in a security's price. Unlike traditional buying and selling of stocks, short selling involves selling first and then buying shares. In this textbook entry, we will explore the concept of short selling, its mechanics, and its associated risks and regulations.

Mechanics of Short Selling

Short selling involves borrowing a share of stock from a broker and immediately selling it in the market. The short-seller anticipates that the stock price will fall, enabling them to repurchase the shares at a lower price in the future. This repurchase is known as "covering the short position" and involves buying back the same number of shares initially sold.

Short-sellers must not only replace the shares but also pay the lender of the security any dividends paid during the short sale.

Borrowed Shares and Brokerage Firms

In practice, shares loaned out for a short sale are typically provided by the short-seller's brokerage firm, which holds a wide variety of securities on behalf of its clients. The brokerage firm may lend shares from its own pool of securities, without the original owners' knowledge. If the owner wishes to sell the shares, the brokerage firm can borrow shares from another investor to facilitate the short sale. This arrangement allows for short sales to have an indefinite term.

However, if the brokerage firm cannot locate new shares to replace the ones sold, the short-seller will need to repay the loan immediately by purchasing shares in the market and turning them over to the brokerage house to close out the loan.

Regulations and Account Requirements

Exchange rules require that proceeds from a short sale must be kept on account with the broker and cannot be invested to generate income. Short-sellers are also required to post margin (cash or collateral) with the broker to cover potential losses if the stock price rises during the short sale.

Additionally, short-sellers need to be mindful of margin calls. If the stock price rises and the margin in the account falls below the maintenance level, the short-seller will receive a margin call.

Stop-Buy Orders for Risk Mitigation

To limit potential losses, short-sellers often use stop-buy orders in conjunction with their short sales. By setting a stop-buy order at a specific price, the short-seller can automatically buy back the shares if the price surpasses the set limit. For example, if a short-seller initiates a short sale of a stock at $100 per share and sets a stop-buy order at $120, the order will be executed if the share price exceeds $120. This mechanism helps mitigate losses and provides protection if the share price moves up.

Controversies and Regulatory Measures

Short-selling periodically comes under scrutiny, particularly during times of financial stress when share prices fall. In response to such situations, regulatory bodies may impose restrictions. For instance, following the 2008 financial crisis, the Securities and Exchange Commission (SEC) voted to restrict short sales in stocks that decline by at least 10% on a given day. These stocks can only be shorted on that day and the following day if the price is higher than the highest bid price across national stock markets.

A variant of short-selling known as naked short-selling involves selling shares that have not yet been borrowed. Although prohibited, enforcement has been inconsistent, with some firms engaging in naked short-selling based on their "reasonable belief" that they will acquire the stock before the delivery deadline. To enhance regulation, the SEC now requires short-sellers to have made firm arrangements for delivery before engaging in the sale.

Loan Value and Price Fluctuations

When buying on margin, investors borrow a fixed amount of dollars from their brokers, making the loan value independent of the share price. In contrast, when short-selling, investors borrow a specific number of shares that must be returned. Therefore, changes in the share price directly impact the value of the loan.

This article takes inspiration from a lesson found in FIN 4504 at the University of Florida.