Securities: Short Selling in the Stock Market

Understanding Short Sales

The Reverse Order: Selling Before Buying

Normally, buying stocks is followed by selling them, but short sales work in reverse. Here, you sell first and then buy the shares, starting and ending with no shares.

Profit from a Decline: The Short Sale Advantage

Short sales enable investors to benefit from a decrease in a security's price. It's like borrowing a friend's bicycle, selling it, and later buying a similar one to return it to your friend. If the price of the bicycle goes down, you can buy it back for less, making a profit.

Covering the Short Position: Returning What You Borrowed

In a short sale, you borrow a share of stock from a broker and sell it. Eventually, you must purchase a share of the same stock to replace the one you borrowed, a process called "covering the short position." It's akin to borrowing a cup of sugar from your neighbor and returning it later by buying a new cup of sugar from the store.

The Short-Seller's Anticipation: Profiting from Falling Prices

A short-seller expects the stock price to decrease, allowing them to buy back the shares at a lower price than they initially sold them for. It's like a shopper who buys an item on sale, anticipating its price will rise in the future so they can sell it at a profit.

Replacing Shares and Paying Dividends: The Short-Seller's Responsibilities

When short-selling, you must not only replace the borrowed shares but also pay any dividends to the lender. Imagine renting a car and returning it with a full tank of gas while also paying for any gas used during the rental period.

Borrowing Shares: How the Brokerage Firm Facilitates Short Sales

Brokerage firms typically provide the shares for short sales from their own pool of securities held on behalf of other investors. The actual owners of the shares might not be aware that their shares are being lent out. If the owner wants to sell their shares, the broker can borrow shares from another investor. This arrangement allows short sales to have an indefinite term. However, if the brokerage firm can't find new shares to replace the ones sold, the short-seller must buy shares from the market to close the loan.

Keeping Proceeds and Posting Margin: Rules for Short-Sellers

Exchange rules dictate that proceeds from a short sale must be kept in the brokerage account and cannot be invested to generate income. Additionally, short-sellers must post margin (cash or collateral) with the broker to cover potential losses if the stock price rises during the short sale. Think of it as having to deposit a security deposit when renting an apartment.

Margin Calls: A Cause for Concern

Similar to investors who purchase stock on margin, short-sellers must be wary of margin calls. If the stock price rises and the margin in the account falls below a certain level (maintenance level), the short-seller will receive a margin call, requiring them to add more funds or collateral to the account to cover potential losses.

Stop-Buy Orders: Protecting Against Losses

Stop-buy orders often accompany short sales to limit potential losses. Suppose you short-sell a stock called Dot Bomb at $100 per share, expecting its price to decline. However, if the share price unexpectedly rises to $130, you would lose $30 per share. To protect yourself, you can set a stop-buy order at $120. If the share price surpasses $120, the stop-buy order will be executed, limiting your losses to $20 per share. The stop-buy order acts as a safety net, just like setting a maximum budget when shopping to avoid overspending.

Regulatory Measures and Naked Short-Selling

During times of financial stress and falling share prices, short-selling often faces criticism. Regulatory bodies, like the SEC, have imposed restrictions on short sales in the past. For example, after the 2008 financial crisis, the SEC limited short sales on stocks that declined by at least 10% on a given day. These stocks could only be shorted on that day and the next, and at prices higher than the highest bid across national stock markets.

Naked Short-Selling: A Risky Variation

Naked short-selling is a variant of conventional short-selling where traders sell shares they haven't yet borrowed. They rely on the belief that they will be able to acquire the shares in time for delivery. Although prohibited, enforcement of this practice has been inconsistent, as some firms engaged in it based on their "reasonable belief." To address this, the SEC now requires short-sellers to make firm arrangements for delivery before engaging in the sale. It's like selling a product online without actually having it in stock, assuming you can procure it later before shipping it to the buyer.

Differences Between Buying on Margin and Short-Selling

When buying on margin, you borrow a specific amount of money from your broker, which remains independent of the share price. However, when short-selling, you borrow a fixed number of shares that must be returned, meaning the value of the loan fluctuates with the changing share price.

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