Short (finance)

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Schematic representation of short selling in two steps. The short seller borrows shares and sells them while the stock price is high. They then wait until the stock price is low and buys back the shares to return to the lender.

In finance, short selling or "shorting" is the practice of selling a financial instrument that the seller does not own at the time of the sale. Short selling is done with the intent of later purchasing the financial instrument at a lower price. Short-sellers attempt to profit from an expected decline in the price of a financial instrument. Short selling or "going short" is contrasted with the more conventional practice of "going long", which typically occurs when a financial instrument is purchased with the expectation that its price will rise. Thus, being "long" is just a way of saying that you own a positive number of the securities; being "short" is just a way of saying that you own a negative number of the securities.

Typically, the short-seller will "borrow" or "rent" the securities to be sold, and later repurchase identical securities for return to the lender. If the security price falls, the short-seller profits from having sold the borrowed securities for more than he later pays for them. However, if the security price rises, the short seller loses by having sold them for less than the price at which he later has to buy them. The practice is risky in that prices may rise without bound, even beyond the net worth of the short seller. The act of repurchasing a shorted security is known as "closing" a position or "covering".

[edit] Concept

To profit from a security price going down, short sellers can borrow the security and sell it, expecting that it will be cheaper to repurchase in the future. When the seller decides that the time is right (or when the lender recalls the securities), the seller buys back the securities in order to return them to the lender. The process generally relies on the fact that securities are fungible, so that the securities returned do not need to be the same securities (i.e. the same physical pieces of paper) as were originally borrowed.

A short seller typically borrows from his broker, who usually in turn has borrowed the securities from some other investor who is holding the securities long; the broker itself seldom actually purchases the securities to lend to the short seller.^[1] The lender of the securities does not lose the right to sell the shares.

Short selling is the opposite of "going long." A short seller takes a fundamentally negative, or "bearish" stance, intending to "sell high and buy-back low," to reverse the conventional adage. The act of buying back the securities which were sold short is called 'covering the short'. Day traders and hedge funds often use short selling to allow them to profit on trading in securities which they believe are overvalued, just as traditional long investors attempt to profit on securities which are undervalued by buying those stocks.

The term "short selling" or "being short" is often also used as a blanket term for strategies that allow an investor to gain from the decline in price of a security. Those strategies include buying options known as puts. A put option consists of the right to sell an asset at a given price; thus the owner of the option benefits when the market price of the asset falls. Similarly, a short position in a futures contract, or to be short on a futures contract, means the holder of the position has an obligation to sell the underlying asset at a later date, to close out the position.

[edit] Example

For example, assume that shares in XYZ Company currently sell for $10 per share. A short seller would borrow 100 shares of XYZ Company, and then immediately sell those shares for a total of $1000. If the price of XYZ shares later falls to $8 per share, the short seller would then buy 100 shares back for $800, return the shares to their original owner and make a $200 profit (minus borrowing fees). This practice has the potential for losses as well. For example, if the shares of XYZ that one borrowed and sold in fact went up to $25, the short seller would have to buy back all the shares at $2500, losing $1500.

Because a short is the opposite of a long (normal) transaction, everything is the mirror opposite compared to the typical trade: the profit is limited but the loss is unlimited. Since the stock cannot be repurchased at a price lower than zero, the maximum gain is the difference between the current stock price and zero. However, because there is no ceiling on how much the stock price can go up (thereby costing short transactions money in order to buy the stocks back), an investor can theoretically lose a substantially large amount of money if a stock continues to rise. In actual practice, however, as the price of XYZ Company began to rise, the short seller would eventually receive a margin call from the brokerage, demanding that the short seller either cover his short position or provide additional cash in order to meet the margin requirement for XYZ Company stock.

[edit] History

The first case of selling short dates back to 1609 and concerns Dutch trader Isaac Le Maire, a big share holder of the Vereenigde Oostindische Compagnie (VOC). In 1602 he invested about 85,000 guilders in the VOC. By 1609 the VOC still was not paying dividend, and Le Maire's ships on the Baltic routes were under constant threats of attack by English ships due to trading conflicts between the British and the VOC. Le Maire decided to sell his shares and sold even more than he had. The notables spoke of an outrageous act and this led to the first real stock exchange regulations: a ban on short selling. The ban was revoked a couple of years later.^[2]

Short selling has been a target of ire since at least the eighteenth century when England banned it outright. It was perceived as a magnifying effect in the violent downturn in the Dutch tulip market in the seventeenth century. In another well-referenced example, George Soros became notorious for "breaking the Bank of England" on Black Wednesday of 1992, when he sold short more than $10 billion worth of pounds sterling.

The term "short" was in use from at least the mid-nineteenth century. It is commonly understood that "short" is used because the short seller is in a deficit position with his brokerage house. Jacob Little was known as The Great Bear of Wall Street who began shorting stocks in the United States in 1822.

Short sellers were blamed for the Wall Street Crash of 1929.^[3] Regulations governing short selling were implemented in the United States 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 downtick; this was known as the uptick rule, and was in effect until 2007. President Herbert 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). A few years later, in 1949, Alfred Winslow Jones founded a fund (that was unregulated) that bought stocks while selling other stocks short, hence hedging some of the market risk, and the hedge fund was born.^[4]

Some typical examples of mass short-selling activity are during "bubbles", such as the Dot-com bubble.^{[citation needed]} At such periods, short-sellers sell hoping for a market correction. Food and Drug Administration (FDA) announcements approving a drug often cause the market to react irrationally due to media attention; short sellers use the opportunity to sell into the buying frenzy and wait for the exaggerated reaction to subside before covering their position.^{[citation needed]} Negative news, such as litigation against a company will also entice professional traders to sell the stock short.

During the Dot-com bubble, shorting a start-up company could backfire since it could be taken over at a higher price than what speculators shorted. Short-sellers were forced to cover their positions at acquisition prices, while in many cases the firm often overpaid for the start-up.

[edit] Short selling restrictions in 2008

In September 2008 short selling was seen as a contributing factor to undesirable market volatility and subsequently was prohibited by the SEC for 799 financial companies for three weeks in an effort to stabilize those companies.^[5] At the same time the U.K. FSA prohibited short selling for 32 financial companies.^[6] On September 22, Australia enacted even more extensive measures with a total ban of short selling.^[7] Also on September 22, the Spanish market regulator, CNMV, required investors to notify it of any short positions in financial institutions, if they exceed 0.25% of a company's share capital.^[8][9] Naked shorting was also restricted.

In an interview with the Washington Post in late December 2008, U.S. Securities and Exchange Commission Chairman Christopher Cox said the decision to impose a three-week ban on short selling of financial company stocks was taken reluctantly, but that the view at the time, including from Treasury Secretary Henry M. Paulson and Federal Reserve chairman Ben S. Bernanke, was that "if we did not act and act at that instant, these financial institutions could fail as a result and there would be nothing left to save." He said that agreeing to the three-week ban on shorting of financial stocks was the biggest mistake of his tenure, and he acknowledged that the ban was not productive. ^[10] In a December 2008 interview with Reuters, he explained that the SEC's Office of Economic Analysis was still evaluating data from the temporary ban, and that preliminary findings point to several unintended market consequences and side effects. "While the actual effects of this temporary action will not be fully understood for many more months, if not years," he said, "knowing what we know now, I believe on balance the Commission would not do it again."^[11]

[edit] Mechanism

Short selling stock consists of the following:

• An investor borrows shares. If required by law, the investor first ensures that cash or equity is on deposit with his brokerage firm as collateral for the initial short margin requirement. Some short sellers, mainly firms and hedge funds, participate in "naked short" selling (see below), where the shorted shares are not borrowed or delivered.
• In either case the investor sells the shares and the proceeds are credited to his broker's account at the firm upon which the firm can earn interest. Generally the short seller does not earn interest on the short proceeds.
• The investor may close the position by buying back the shares (called covering). If the price has dropped, he makes a profit. If the stock advanced he takes a loss.
• Finally, the investor may return the shares to the lender or stay short indefinitely.

[edit] Shorting stock in the U.S.

In the U.S., in order to sell stocks short, the seller must arrange for a broker-dealer to confirm that it is able to make delivery of the shorted securities. This is referred to as a "locate." Brokers have a variety of means to borrow stocks in order to facilitate locates and make good delivery of the shorted security.

The vast majority of stock borrowed by U.S. brokers come from loans made by the leading custody banks and fund management companies (see list below). Sometimes brokers are able to borrow stocks from their customers who own "long" positions. In these cases, if the customer has fully paid for the long position, the broker cannot borrow the security without the express permission of the customer, and the broker must provide the customer with collateral and pay a fee to the customer. In cases where the customer has not fully paid for the long position (meaning the customer borrowed money from the broker in order to finance the purchase of the security), the broker will not need to inform the customer that the long position is being used to effect delivery of another client's short sale.

Most brokers will allow retail customers to borrow shares to short a stock only if one of their own customers has purchased the stock on margin. Brokers will go through the "locate" process outside their own firm to obtain borrowed shares from other brokers only for their large institutional customers.

Stock exchanges such as the NYSE or the NASDAQ typically report the "short interest" of a stock, which gives the number of shares that have been sold short as a percent of the total float. Alternatively, these can also be expressed as the short interest ratio, which is the number of shares sold short as a multiple of the average daily volume. These can be useful tools to spot trends in stock price movements.

[edit] Securities lending

When a security is sold, the seller is contractually obliged to deliver it to the buyer. If a seller sells a security short without owning it first, the seller needs to borrow the security from a third party to fulfill its obligation. Otherwise, the seller will "fail to deliver," the transaction will not settle, and the seller is subject to a claim from its counterparty. Certain large holders of securities, such as a custodian or investment management firm, often lend out these securities to gain extra income, a process known as 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.

[edit] Sources of short interest data

Time delayed short interest data is available in a number of countries, including the US, the UK, Hong Kong and Spain. Some market participants (like Data Explorers) believe that stock lending data provides a good proxy for short interest levels. The amount of stocks being shorted on a global basis has increased in recent years for various structural reasons (e.g. the growth of 130/30 type strategies).

[edit] Short selling terms

Days to Cover (DTC) is a numerical term that describes the relationship between the amount of shares in a given equity that have been short sold and the number of days of typical trading that it would require to 'cover' all short positions outstanding. For example, if there are ten million shares of XYZ Inc. that are currently short sold and the average daily volume of XYZ shares traded each day is one million, it would require ten days of trading for all short positions to be covered (10 million / 1 million).

Short Interest is a numerical term that relates the number of shares in a given equity that have been shorted divided by the total shares outstanding for the company, usually expressed as a percent. For example, if there are ten millions shares of XYZ Inc. that are currently short sold and the total number of shares issued by the company is one hundred million, the Short Interest is 10% (10 million / 100 million).

[edit] Major lenders

• State Street Corporation (Boston)
• JP Morgan Chase (New York)
• Northern Trust (Chicago)
• Fortis (Amsterdam)
• Citibank (New York)
• Bank of New York Mellon Corporation (New York)
• UBS AG (Zurich, Switzerland)

[edit] Naked short sale

A naked short sale occurs when a security is sold short without first ascertaining that one can borrow the security. In the US, making arrangements to borrow a security before a short sale is called a locate. In 2005, to prevent widespread failure to deliver securities, the U.S. Securities and Exchange Commission (SEC) put in place Regulation SHO, which prevents investors from selling some stocks short before doing a locate. More stringent requirements were put in place in September 2008, to prevent the practice from exacerbating market declines.

[edit] Fees

When a broker facilitates the delivery of a client's short sale, the client is charged a fee for this service, usually a standard commission similar to that of purchasing a similar security.

If the short position begins to move against the holder of the short position (i.e., the price of the security begins to rise), money will be removed from the holder's cash balance and moved to his or her margin balance. If short shares continue to rise in price, and the holder does not have sufficient funds in the cash account to cover the position, the holder will begin to borrow on margin for this purpose, thereby accruing margin interest charges. These are computed and charged just as for any other margin debit.

When a security's ex-dividend date passes, the dividend is deducted from the shortholder's account and paid to the person from whom the stock was borrowed.

For some brokers, the short seller may not earn interest on the proceeds of the short sale or use it to reduce outstanding margin debt. These brokers may not pass this benefit on to the retail client unless the client is very large. This means an individual short-selling $1000 of stock will lose the interest to be earned on the $1000 cash balance in his or her account.

[edit] Dividends and voting rights

Where shares are shorted and the company which issues the shares distributes a dividend, the question arises as to who receives the dividend. The new buyer of the shares, who is the "holder of record" and holds the shares outright, will receive the dividend from the company. However, the lender, who may hold its shares in a margin account with a prime broker and is unlikely to be aware that these particular shares are being lent out for shorting, also expects to receive a dividend. The short seller will therefore pay to the lender an amount equal to the dividend in order to compensate, though as this payment does not come from the company it is not technically a dividend as such. The short seller is therefore said to be "short the dividend".

A similar issue comes up with the voting rights attached to the shares. However, unlike a dividend, voting rights cannot be synthesised. The buyer of the shorted share, as the holder of record, therefore controls the voting rights, whereas the owner of a margin account agrees in advance to relinquish voting rights to shares during the period of any short sale.^[12]

[edit] Markets

[edit] Futures and options contracts

When trading futures contracts, being 'short' means having the legal obligation to deliver something at the expiration of the contract, although the holder of the short position may alternately buy back the contract prior to expiration instead of making delivery. Short futures transactions are often used by producers of a commodity to fix the future price of goods they have not yet produced. Shorting a futures contract is sometimes also used by those holding the underlying asset (i.e. those with a long position) as a temporary hedge against price declines. Shorting futures may also be used for speculative trades, in which case the investor is looking to profit from any decline in the price of the futures contract prior to expiration.

An investor can also purchase a put option, giving that investor the right (but not the obligation) to sell the underlying asset (such as shares of stock) at a fixed price. In the event of a market decline, the option holder may exercise these put options, obliging the counterparty to buy the underlying asset at the agreed upon (or "strike") price, which would then be higher than the current quoted spot price of the asset.

[edit] Currency

Selling short on the currency markets is different from selling short on the stock markets. Currencies are traded in pairs, each currency being priced in terms of another, so there is no possibility for any single currency to get to zero. In this way selling short on the currency markets is identical to selling long on stocks.

Novice traders or stock traders can be confused by the failure to recognize and understand this point: a contract is always long in terms of one medium and short another.

When the exchange rate has changed, the trader buys the first currency again; this time he gets more of it, and pays back the loan. Since he got more money than he had borrowed initially, he makes money. Of course, the reverse can also occur.

An example of this is as follows: Let us say a trader wants to trade with the dollar and the Indian rupee currencies. Assume that the current market rate is $1 to Rs.50 and the trader borrows Rs.100. With this, he buys $2. If the next day, the conversion rate becomes $1 to Rs.51, then the trader sells his $2 and gets Rs.102. He returns Rs.100 and keeps the Rs.2 profit.

One may also take a short position in a currency using futures or options; the preceding method is used to bet on the spot price, which is more directly analogous to selling a stock short.

[edit] Risk

Note: this section does not apply to currency markets.

It is important to note that buying shares (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.

Many. short sellers place a "stop loss order" with their stockbroker after selling a stock short. This is an order to the brokerage to cover the position if the price of the stock should rise to a certain level, in order to limit the loss and avoid the problem of unlimited liability described above. In some cases, if the stock's price skyrockets, the stockbroker may decide to cover the short seller's position immediately and without his consent, in order to guarantee that the short seller will be able to make good on his debt of shares.

The risk of large potential losses through short selling inspired financier Daniel Drew to warn:

"He who sells what isn't his'n, must buy it back or go to pris'n"

Short selling is sometimes referred to as a "negative income investment strategy" because there is no potential for dividend income or interest income. One's return is strictly from capital gains.

Short sellers must be aware of the potential for a short squeeze. When the price of a stock rises significantly, some people who are shorting the stock will cover their positions to limit their losses (this may occur in an automated way if the short sellers had stop-loss orders in place with their brokers); others may be forced to close their position to meet a margin call; others may be forced to cover, subject to the terms under which they borrowed the stock, if the person who lent the stock wishes to sell and take a profit. Since covering their positions involves buying shares, the short squeeze causes an ever further rise in the stock's price, which in turn may trigger additional covering. Because of this, most short sellers restrict their activities to heavily traded stocks, and they keep an eye on the "short interest" levels of their short investments. Short interest is defined as the total number of shares that have been sold short, but not yet covered.

On occasion, a short squeeze is deliberately induced. This can happen when a large investor (a company or a wealthy individual) notices significant short positions, and buys many shares, with the intent of selling the position at a profit to the short sellers who will be panicked by the initial uptick or who are forced to cover their short positions in order to avoid margin calls.

Short sellers have to deliver the securities to their broker eventually. At that point they will need money to buy them, so there is a credit risk for the broker. To reduce this, the short seller has to keep a margin with the broker.

Short sellers tend to temper overvaluation by selling into exuberance. Likewise, short sellers often provide price support by buying when negative sentiment is exacerbated during a significant price decline. Short selling can have negative implications if it causes a premature or unjustified share price collapse when the fear of cancellation due to bankruptcy becomes contagious.

Finally, short sellers must remember that they are going against the overall upward direction of the market. This, combined with interest costs, can make it unattractive to keep a short position open for a long duration.

[edit] Strategies

[edit] Speculation

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A seller intentionally takes on directional risk in the belief that the value of the shorted asset will fall.

[edit] Hedging

Hedging often represents a means of minimizing the risk from a more complex set of transactions. Examples of this are:

• a farmer who has just planted his wheat wants to lock in the price at which he can sell after the harvest. He would take a short position in wheat futures.
• a market maker in corporate bonds is constantly trading bonds when clients want to buy or sell. This can create substantial bond positions. The largest risk is that interest rates overall move. The trader can hedge this risk by selling government bonds short against his long positions in corporate bonds. In this way, the risk that remains is credit risk of the corporate bonds.
• an options trader may short shares in order to remain delta neutral so that he is not exposed to risk from price movements in the stocks that underlie his options

[edit] Arbitrage

A short seller may be trying to benefit from market inefficiencies arising from the mispricing of certain products. Examples of this are

• an arbitrageur who buys long futures contracts on a US Treasury security, and sells short the underlying US Treasury security.

[edit] Against the box

One variant of selling short involves a long position. "Selling short against the box" is holding a long position on which one enters a short sell order. The term box alludes to the days when a safe deposit box was used to store (long) shares. The purpose of this technique is to lock in paper profits on the long position without having to sell that position (and possibly incur taxes if said position has appreciated). Whether prices increase or decrease, the short position balances the long position and the profits are locked in (less brokerage fees and short financing costs).

U.S. investors considering entering into a "short against the box" transaction should be aware of the tax consequences of this transaction. Unless certain conditions are met, the IRS deems a "short against the box" position to be a "constructive sale" of the long position, which is a taxable event. These conditions include a requirement that the short position be closed out within 30 days of the end of the year and that the investor must hold their long position, without entering into any hedging strategies, for a minimum of 60 days after the short position has been closed.^[13]

[edit] Criticism

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Short sellers are sometimes regarded with suspicion because, in the views of some people^[14], they are profiting from the misfortune of others. Occasionally businesses campaign against short sellers who target them, even resulting in litigation.

Advocates of short sellers say that the practice is an essential part of the price discovery mechanism.^[15] They state that short-seller scrutiny of companies' finances has led to the discovery of instances of fraud which were glossed over or ignored by investors who had held the companies' stock long. Some hedge funds and short sellers claimed that the accounting of Enron and Tyco was suspicious months before their respective financial scandals emerged. Financial researchers at Duke University have provided statistically significant support for the assertion that short interest is an indicator of poor future stock performance and that short sellers exploit market mistakes about firms' fundamentals.^[16]

Such noted investors as Seth Klarman and Warren Buffett have said that short sellers help the market. Klarman argued that short sellers are a useful counterweight to the widespread bullishness on Wall Street,^[17] while Buffett believes that short sellers are useful in uncovering fraudulent accounting and other problems at companies.^[18] In response to the UK and US moves to ban short selling in September 18 and 19 of 2008, UBS stated:

This can be characterized as a populist reaction of no positive value. Anyone who seriously thinks that the cause of this crisis arises from the actions of evil and manipulative speculators lacks the insight and knowledge to be allowed anywhere near the regulation of financial markets. Short selling may well exacerbate problems, but it was not the cause.

—UBS Investment research's daily roundup^[19]

UBS expanded its opinion stating that the banning of short selling is a "policy error" that created problems, referring to the OECD bans of 2008.^[20]

[edit] The regulatory response

In the US, Regulation SHO was the SEC's first update to short selling restrictions since 1938. It established "locate" and "close-out" requirements for broker-dealers, in an effort to curb naked short selling. Compliance with the regulation began on January 3, 2005.^[21]

In the US, initial public offerings (IPOs) cannot be sold short for a month after they start trading. This mechanism is in place to ensure a degree of price stability during a company's initial trading period. However, some brokerages that specialize in penny stocks (referred to colloquially as bucket shops) have used the lack of short selling during this month to pump and dump thinly traded IPOs. Canada and other countries do allow selling IPOs (including U.S. IPOs) short.

In the UK, the Financial Services Authority had a moratorium on short selling 29 leading financial stocks, effective from 2300 GMT, 18 September 2008 until 16 January 2009.^[22]

After the ban was lifted, John McFall, chairman of the Treasury Select Committee, House of Commons, made clear in public statements and a letter to the FSA that he believed it ought to be extended.

In the US, a similar response was made by the Securities and Exchange Commission with a ban on short selling on 799 financial stocks from 19 September 2008 until 2 October 2008. Greater penalties for naked shorting, by mandating delivery of stocks at clearing time, were also introduced. Some state governors have been urging state pension bodies to refrain from lending stock for shorting purposes. ^[23]

Soon thereafter, between 19 and 21 September 2008, Australia temporarily banned short selling,^[24], and later placed an indefinite ban on naked short selling ^[25]. The ban on short selling was further extended for another 28 days on 21 October 2008^[26].Germany, Ireland, Switzerland and Canada banned short selling leading financial stocks,^[27] and France, The Netherlands and Belgium banned naked short selling leading financial stocks.^[28].

By contrast, Chinese regulators have responded by allowing short selling, along with a package of other market reforms.^[29]

An assessment of the effect of a ban on short-selling that was enacted in many countries in the fall of 2008 showed that it had only "little impact" on the movements of stocks, with stock prices moving in the same way as they would have moved anyhow, but the ban reduced volume and liquidity.^[30] By December countries in Europe were considering to remove the ban, while the ban in the US was already lifted in October 2008.

[edit] See also

• Inverse exchange-traded fund
• Joseph Parnes
• Long (finance)
• Manuel P. Asensio
• Repurchase agreement
• Securities lending
• Short ratio
• Socially responsible investing
• Speculation
• Straddle
• Uptick rule

[edit] References

[edit] External links and sources

• Porsche VW Shortselling Scandal
• "Short-Selling Bans Dampen 130/30 Strategies Worldwide," Global Investment Technology, Sept. 29, 2008
• Market Beat
• Seeking Alpha
• Data Explorers
• Short Stories
• How to Identify Short Squeezes
• Short Selling Introduction
• Short Interest: What it tells us
• SEC Discussion of Naked Short Selling
• '"Financial Interest Disclosures Can Protect Markets From 'Short & Distort' Manipulators", Alex J. Pollock, June 6 2006, Washington Legal Foundation
• Coverage of controversial short-selling 'conspiracy' lawsuits by tobacco litigation specialists in US: Short Tempers, Risk Magazine (2006), Navroz Patel
• Don't Sell Short Selling Short
• High Short Interest