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Short Selling Tutorial

By Brigitte Yuille 

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As always, we welcome any feedback or suggestions.http://www.investopedia.com/contact.aspx 

Table of Contents

1) Short Selling: Introduction2) Short Selling: What is Short Selling?3) Short Selling: Why Short?4) Short Selling: The Transaction5) Short Selling: The Risks6) Short Selling: Ethics and the Role of Short Selling7) Short Selling: Conclusion

Introduction

Have you ever been absolutely sure that a stock was going to decline andwanted to profit from its regrettable demise? Have you ever wished that youcould see your portfolio increase in value during a bear market? Both scenariosare possible. Many investors make money on a decline in an individual stock orduring a bear market, thanks to an investing technique called short selling. (Forrelated reading, see When To Short A Stock .)

Short selling is not complex, but it's a concept that many investors have troubleunderstanding. In general, people think of investing as buying an asset, holding itwhile it appreciates in value, and then eventually selling to make a profit.Shorting is the opposite: an investor makes money only when a shorted security

falls in value.

Short selling involves many unique risks and pitfalls to be wary of. Themechanics of a short sale are relatively complicated compared to a normaltransaction. As always, the investor faces high risks for potentially high returns.

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It's essential that you understand how the whole process works before you getinvolved. 

What Is Short Selling?

First, let's describe what short selling means when you purchase shares of stock.In purchasing stocks, you buy a piece of ownership in the company. The buyingand selling of stocks can occur with a stock broker or directly from thecompany. Brokers are most commonly used. They serve as an intermediarybetween the investor and the seller and often charge a fee for their services.

When using a broker, you will need to set up an account. The account that's setup is either a cash account or a margin account. A cash account requires thatyou pay for your stock when you make the purchase, but with a margin accountthe broker lends you a portion of the funds at the time of purchase and the

security acts as collateral.

When an investor goes long on an investment, it means that he or she hasbought a stock believing its price will rise in the future. Conversely, when aninvestor goes short, he or she is anticipating a decrease in share price.

Short selling is the selling of a stock that the seller doesn't own. More specifically,a short sale is the sale of a security that isn't owned by the seller, but that ispromised to be delivered. That may sound confusing, but it's actually a simpleconcept. (To learn more, read Benefit From Borrowed Securities .)

Still with us? Here's the skinny: when you short sell a stock, your broker will lendit to you. The stock will come from the brokerage's own inventory, from anotherone of the firm's customers, or from another brokerage firm. The shares are soldand the proceeds are credited to your account. Sooner or later, you must "close"the short by buying back the same number of shares (called covering) andreturning them to your broker. If the price drops, you can buy back the stock atthe lower price and make a profit on the difference. If the price of the stock rises,you have to buy it back at the higher price, and you lose money.

Most of the time, you can hold a short for as long as you want, although interestis charged on margin accounts, so keeping a short sale open for a long time will

cost more However, you can be forced to cover if the lender wants the stock youborrowed back. Brokerages can't sell what they don't have, so yours will eitherhave to come up with new shares to borrow, or you'll have to cover. This isknown as being called away. It doesn't happen often, but is possible if manyinvestors are short selling a particular security.

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Because you don't own the stock you're short selling (you borrowed and thensold it), you must pay the lender of the stock any dividends or rights declaredduring the course of the loan. If the stock splits during the course of your short,you'll owe twice the number of shares at half the price. (To learn more about

stock splits, read Understanding Stock Splits .)

Why Short?

Generally, the two main reasons to short are to either speculate or to hedge.

Speculate When you speculate, you are watching for fluctuations in the market in order toquickly make a big profit off of a high-risk investment. Speculation has beenperceived negatively because it has been likened to gambling. However,speculation involves a calculated assessment of the markets and taking riskswhere the odds appear to be in your favor. Speculating differs from hedgingbecause speculators deliberately assume risk, whereas hedgers seek to mitigateor reduce it. (For more insight, see What is the difference between hedging and speculation? ) 

Speculators can assume a high loss if they use the wrong strategies at the wrongtime, but they can also see high rewards. Probably the most famous example ofthis was when George Soros "broke the Bank of England" in 1992. He risked $10billion that the British pound would fall and he was right. The following night,Soros made $1 billion from the trade. His profit eventually reached almost $2billion. (For more on this trade, see The Greatest Currency Trades Ever Made .)

Speculators can benefit the market because they increase trading volume,assume risk and add market liquidity. However, high amounts of speculativepurchases can contribute to an economic bubble and/or a stock market crash.

HedgeFor reasons we'll discuss later, very few sophisticated money managers short asan active investing strategy (unlike Soros). The majority of investors use shorts tohedge. This means they are protecting other long positions with offsetting shortpositions.

Hedging can be a benefit because you're insuring your stock against risk, but itcan also be expensive and a basis risk can occur. (To learn more about hedging,read A Beginner's Guide To Hedging .)

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RestrictionsMany restrictions have been placed on the size, price and types of stocks tradersare able to short sell. For example, penny stocks cannot be sold short, and mostshort sales need to be done in round lots. The Securities Exchange Commission(SEC) has these restrictions in place to prevent the manipulation of stock prices.

As of January 2005, short sellers were also required to comply with the rules setin place by "Regulation SHO", which modernized the rules overseeing shortselling and aimed to provide safeguards against "naked short selling." Forinstance, sellers had needed to show that they could locate and get the securitiesthey intended to short. The regulation also created a list of securities showing ahigh level of persistent sales to deliver.

In July of 2007, the SEC eliminated the uptick, or zero plus tick, rule. This rulerequired that every short sale transaction be entered at a higher price than that ofthe previous trade and kept short sellers from adding to the downward

momentum of an asset when it was already experiencing sharp declines. Therule has been around since the creation of the SEC in 1934. One of the reasonsit was put in place was to slow rapid and sudden declines in share prices that canoccur as a result of short selling.

In July of 2008, the SEC used its emergency powers to put an end to marketmanipulations, such as spreading negative rumors about a company'sperformance and sharp price declines. The markets had been volatile as a resultof the of mortgage and credit crisis, and the SEC wanted to establish a renewedconfidence. For a month, it didn't allow naked short selling on the stocks of 19major investment and commercial banks, which included the mortgage finance

companies Fannie Mae and Freddie Mac. (To learn more, read The Uptick Rule: Does It Keep Bear Markets Ticking? ) 

The SEC took further measures in September of 2008, once again using itsemergency authority to issue six orders to minimize abuses. This included amove to halt short selling in shares of 799 companies in cooperation with theUnited Kingdom's Financial Service Authority. 170 companies were later includedin the ban, which ended after the passage of the $700 billion U.S. bailout plan inOctober 2008. Another order required short sellers get a sale and immediatelyclose it by making sure the shares were delivered. It later became a rule.

Who Shorts?Some insiders indicate that it takes a certain type of person to short stocks.

Many short sellers have been depicted as pessimists who are rooting for acompany's failure, but they've also been described as disciplined and confident intheir judgment. (To learn more, read Questioning The Virtue Of A Short Sale .)

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Sellers are typically:

  wealthy sophisticated investors  hedge funds

  large institutions  day traders 

Short selling isn't for everyone. It involves a great amount of time and dedication.Short sellers need to be informed, skilled and experienced investors in order tosucceed.

They must know:

  how securities markets work  trading techniques and strategies

  market trends  the firm's business operations

The Transaction

Suppose that, after hours of painstaking research and analysis, you decide thatcompany XYZ is dead in the water. The stock is currently trading at $65, but youpredict it will trade much lower in the coming months. In order to capitalize on thedecline, you decide to short sell shares of XYZ stock. Let's take a look at how this

transaction would unfold.

Step 1: Set up a margin account. Remember, this account allows you to borrowmoney from the brokerage firm using your investment as collateral.

Step 2: Place your order by calling up the broker or entering the trade online.Most online brokerages will have a check box that says "short sale" and "buy tocover." In this case, you decide to put in your order to short 100 shares.

Step 3: The broker, depending on availability, borrows the shares. According tothe SEC, the shares the firm borrows can come from:

  the brokerage firm's own inventory  the margin account of one of the firm's clients  another brokerage firm

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You should also be mindful of the margin rules and know that fees and chargescan apply. For instance, if the stock has a dividend, you need to pay the personor firm making that loan. (To learn more, read the Margin Trading  tutorial.)

Step 4: The broker sells the shares in the open market. The profits of the sale

are then put into your margin account.

One of two things can happen in the coming months:

The Stock Price Sinks (stock goes to $40)

Borrowed 100 shares of XYZ at $65 $6,500 

Bought Back 100 shares of XYZ at $40 -$4,000 

Your Profit $2,500 

The Stock Price Rises (stock goes to $90)

Borrowed 100 shares of XYZ at $65 $6,500 

Bought Back 100 shares of XYZ at $90 -$9,000 

Your Profit -$2,500 

Clearly, short selling can be profitable. But then, there's no guarantee that theprice of a stock will go the way you expect it to (just as with buying long).

Shorter sellers use an endless number of metrics and ratios to find shortable

candidates. Some use a similar stock picking methodology to the longs, but justshort the stocks that come out worst. Others look for insider trading, changes inaccounting policy, or bubbles waiting to pop.

One indicator specific to shorts that is worth mentioning is short interest. Shortinterest is the total number of stocks, securities or commodity shares in anaccount or in the markets that have been sold short, but haven't beenrepurchased in order to close the short position. It serves as a barometer for abearish or bullish market. For instance, the higher the short interest, the morepeople will anticipate a downturn. (For more insight, read Short Interest: What It Tells Us .)

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The Risks

Now that we've introduced short selling, let's make one thing clear: shorting isrisky. Actually, we'll rephrase that. Shorting is very, very risky. It's not unlikerunning with the bulls in Spain: you can either have a great time, or you can get

trampled.

You can think of the outcome of a short sale as basically the opposite of aregular buy transaction, but the mechanics behind a short sale result in someunique risks.

1.  Short selling is a gamble. History has shown that, in general, stockshave an upward drift. Over the long run, most stocks appreciate in price.For that matter, even if a company barely improves over the years,inflation should drive its stock price up somewhat. What this means is that

shorting is betting against the overall direction of the market.So, if the direction is generally upward, keeping a short position open for along period can become very risky. (To learn more, read Stocks Are No.1 and The Stock Market: A Look Back .) 

2. Losses can be infinite. When you short sell, your losses can be infinite.A short sale loses when the stock price rises and a stock is (theoretically,at least) not limited in how high it can go. For example, if you short 100shares at $65 each hoping to make a profit but the shares increase to $90apiece, you end up losing $2,500. On the other hand, a stock can't gobelow 0, so your upside is limited. Bottom line: you can lose more thanyou initially invest, but the best you can earn is a 100% gain if a companygoes out of business and the stock loses its entire value.

3. Shorting stocks involves using borrowed money. This is known asmargin trading. When short selling, you open a margin account, whichallows you to borrow money from the brokerage firm using yourinvestment as collateral. Just as when you go long on margin, it's easy forlosses to get out of hand because you must meet the minimummaintenance requirement of 25%. If your account slips below this, you'llbe subject to a margin call, and you'll be forced to put in more cash orliquidate your position. (We won't cover margin in detail here, but you canread more in our Margin Trading tutorial .)

4. Short squeezes can wring the profit out of your investment. Whenstock prices go up short seller losses get higher, as sellers rush to buy thestock to cover their positions. This rush creates a high demand for thestock quickly driving up the price even further. This phenomenon is known

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as a short squeeze. Usually, news in the market will trigger a shortsqueeze, but sometimes traders who notice a large number of shorts in astock will attempt to induce one. This is why it's not a good idea to short astock with high short interest. A short squeeze is a great way to lose a lotof money extremely fast. (To learn more, see Short Squeeze The Last 

Drop Of Profit From Market Moves .)

5. Even if you're right, it could be at the wrong time. The final and largestcomplication is being right too soon. Even though a company isovervalued, it could conceivably take a while to come back down. In themeantime, you are vulnerable to interest, margin calls and being calledaway. Academics and traders alike have tried for years to come up withexplanations as to why a stock's market price varies from its intrinsicvalue. They have yet to come up with a model that works all the time, andprobably never will.

Take the dotcom bubble, for example. Sure, you could have made a killingif you shorted at the market top in the beginning of 2000, but manybelieved that stocks were grossly overvalued even a year earlier. You'd bein the poorhouse now if you had shorted the Nasdaq in 1999! That's whenthe Nasdaq was up 86%, although two-thirds of the stocks declined. Thisis contrary to the popular belief that pre-1999 valuations more accuratelyreflected the Nasdaq. However, it wasn't until three years later, in 2002,that the Nasdaq returned to 1999 levels.

Momentum is a funny thing. Whether in physics or the stock market, it'ssomething you don't want to stand in front of. All it takes is one big shortingmistake to kill you. Just as you wouldn't jump in front of a pack of stampedingbulls, don't fight against the trend of a hot stock.

Ethics And The Role Of Short Selling

It's safe to say that short sellers aren't the most popular people on Wall Street. Many investors see short selling as "un-American" and "betting against the hometeam" because these sellers are perceived to seek out troubled companies.

Some critics even believe that short sales are a major cause of marketdownturns, such as the crash in 1987. There isn't a whole lot of evidence tosupport this, as other factors such as derivatives and program trading alsoplayed a massive role, but two years after the crash, the U.S. government heldthe 1989 House subcommittee hearing on short selling. Lawmakers wanted to

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look at the effects short sellers had on small companies and examined the needfor regulation after allegations of widespread manipulation by short sellers ofover-the-counter stocks. SEC officials reassured the public that manipulationshadn't been uncovered and more rules would be put in place. (To learn more,read Questioning The Virtue Of A Short Sale  and The Uptick Rule: Does It Keep 

Bear Markets Ticking? ) 

But despite its critics, it's tough to deny that short selling makes an importantcontribution to the market by:

  Adding liquidity to share transactions. The additional buying and sellingreduces the difference between the price at which shares can be boughtand sold.

  Driving down overpriced securities by lowering the cost to execute a trade  Increasing the overall efficiency of the markets by quickening price

adjustments

  Acting as the first line of defense against financial fraud. For instance, in2001, famed short seller James Chanos identified fraudulent accountingpractices that occurred with the Enron Corporation, an energy-trading andutilities company. The company's activity became known as the Enronscandal when the company was found to have inflated its revenues. It filedChapter 11 bankruptcy at the end of 2001. (To learn more about thisscandal, see The Biggest Stock Scams Of All Time .)

While the conflicts of interest from investment banking keep some analysts fromgiving completely unbiased research, work from short sellers is often regarded as

being some of the most detailed and highest quality research in the market. It'sbeen said that short sellers actually prevent crashes because they provide avoice of reason during raging bull markets.

However, short selling also has a dark side, courtesy of a small number oftraders who are not above using unethical tactics to make a profit. Sometimesreferred to as the "short and distort," this technique takes place when tradersmanipulate stock prices in a bear market by taking short positions and then usinga smear campaign to drive down the target stocks. This is the mirror version ofthe pump and dump, where crooks buy stock (take a long position) and issuefalse information that causes the target stock's price to increase. Short sellingabuse like this has grown along with internet trading and the growing trend ofsmall investors and online trading. (For more insight, read The Short And Distort: Stock Manipulation In A Bear Market .) 

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Conclusion

Short selling is another technique you can add to your trading toolbox. That is, ifit fits with your risk tolerance and investing style. Short selling provides a sizableopportunity with a hefty dose of risk. We hope this tutorial has enabled you to

understand whether it's something you would like to pursue. Let's recap:

  In a short sale, an investor borrows shares, sells them and musteventually return the same shares (cover). Profit (or loss) is made on thedifference between the price at which the shares are borrowed comparedto when they are returned.

  An investor makes money only when a shorted security falls in value.  Short selling is done on margin, and so is subject to the rules of margin

trading.  The shorter must pay the lender any dividends or rights declared during

the course of the loan.

  The two reasons for shorting are to speculate and to hedge.   There are restrictions as to what stocks can be shorted and when a short

can be carried out (uptick rule).  Short interest tells us the number of shares that have already been sold

short in a security.  Short selling is very risky. You can lose more money than you invest but

are limited to 100% profit on the upside.  A short squeeze is when a large number of short sellers try to cover their

positions at the same time, driving up the price of a stock.  Even though a company is overvalued, it may take a long time for it to

come back down. Fighting the trend almost always leads to trouble.

  Critics of short selling see it as unethical and bad for the market.  Short selling contributes to the market by providing liquidity, efficiency and

acting as a voice of reason in bull markets.  Some unethical traders spread false information in an attempt to drive the

price of a stock down and make a profit by selling short.