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On Selling "Short"

Once you have fixed up an account with a broker you don't have to buy in order to commence trading - you can sell "short", that is sell shares that you don't own. By selling "short" you sell something you don't have because you have reckoned that it will lose value and that you'll therefore be able to buy it 'back' at a lower price. This article is focused on the various possibilities and realities of being short. Some of it's good, some of it's bad, and some of it gets downright ugly. Let's start with the good:

The Good Part of Being Short a Stock: If the stock goes down, you make money. Contrary to some people's thinking, this is not an un-American activity. In fact, the short sellers add liquidity to a stock. However, if you look at a chart for the general market, you'll see that the trend has been up for years. Being a short seller means you're definitely going against the trend.

The Bad Part of Being Short a Stock:
1)You pay the dividends on the stock when you're short. If you've shorted XYZ and it pays a 50 cent dividend while you're short, then you have to pay the 50 cents per share for every share you're short.

2) You pay margin costs on your short position. Even though you've shorted the stock (sold it), and have a credit balance in your account, you are charged margin interest on most of the balance. Very large institutional clients don't pay these rates, but most likely you will. That's on top of the dividends you also have to pay plus the commission for shorting the stock and then buying it back.

3) You may have the short covered (bought back in) by your brokerage firm before you want to get out of the position. If you've shorted a stock and it doesn't have a lot of shares outstanding or if there is a sudden surge of buying interest in the stock you've shorted, then your broker has the right, at any time, to buy your position in. Remember that when you short a stock: you've only borrowed the shares from another account. You didn't own them. So if that particular account from which you borrowed the shares wants to sell the shares it loaned to you, then the broker must borrow other shares to fill the sale. However, if there are no other shares to borrow, then the broker can go into the open market, buy the stock back to cover your position so that you would then be "flat", i.e., have no position at all, and take the new shares just purchased and give them to the client where the shares were originally borrowed. Obviously, when you short a stock, you don't have full control of the trade, and you can lose your short (and shirt) just when you think the stock will start to turn around and go back down.

4) You can get "squeezed". Squeezing the shorts is one of the favorite games of Wall Street. One thing you have to understand about shorting a stock is that you must, at some point, buy it back. It's not like a stock you buy and can hold forever. Being short a stock means you must buy it in to make a profit. And if the stock is going up rapidly, then you must decide whether to cover your short (buy back your stock) or continue the agony of watching a stock moving up, every tick inflicting pain as the stock moves you deeper into a loss position. The reason for all this background is to understand the game of squeezing the shorts. When a stock has a very large short position, many large players will often try to make trading gains in the stock by buying the stock and hope to "squeeze" the short sellers into buying it back, either because they need to or because the pain is too great. Once the squeeze starts and the shorts begin to cover, the stock has to go up because all the shorts have to buy the stock in order to eliminate their short positions. It's not pretty, but then no one said investing is pretty. Sometimes, if you listen close enough, you can hear the short sellers screaming as their favorite short stocks are being squeezed.

5) All profits made from shorts are taxed at regular income tax rates. Even if you've had the short on for two years, when you cover and make a profit, you will pay the regular, short term income tax rate on the trade.

The Ugly: No, being squeezed isn't the ugliest part of being short. That distinction goes to the fact that when you short a stock there is no limit to the amount of money you can lose. If you buy a stock, you can lose all of your investment. Period. Move on to the next sure thing. However, when you short a stock, there is no limit to your losses until you buy the stock back or are forced to by the brokerage firm from which you borrowed the stock. In other words, the losses can be infinite but the gain can only be as much money as you've shorted. If the stock you short is a $20 stock and it goes to $0, then you've made 20 points. You can't make more than that because the stock can't go lower than zero. Of course, with the margin aspect of a short position which allows leverage you can make more on your capital than just the 20 points but the concept remains the same: you can't make any more money than when the stock goes to zero. Very few stocks do that so you'd be lucky to see the stock that low. However, in the loss column, there is no cap. A stock that you short at $20 can go to $30, then $60, then $100, then it can split and start all over again. So there's no end to the amount of money you can lose.

All of this is to say that shorting stocks is like getting married: don't enter into it lightly. While the concept sounds simple, the reality is very complex. Unless you're willing to put limits on your losses and watch the stock carefully, you don't want to be in this part of Wall Street. There are too many skeletons there already. Don't play this game unless you've got a good understanding of selling short and the ability to cut your losses quickly.

Thanks to Ted Allrich.

SELLING SHORT
When you sell a stock short, you are selling borrowed shares in the
hope that the price will later fall and you will be able to later buy
them back at a profit. Your broker takes care of all the paperwork in the
back office for you, so you don't have to worry about looking for shares
to borrow.

PLACING AN ORDER
You place an order such as "Sell short 100 shares of XYZ" with your
broker in the usual fashion. The word "short" alerts your broker that
you do not own any shares of XYZ. He must first find shares of XYZ in a
margin account somewhere so that you can borrow them to make this sale.
Generally, there is no problem finding such shares. The exceptions are small
stocks that have disproportionately large trading volumes. If your broker
is unable to locate shares for borrowing, your order will simply be rejected.

THE UPTICK RULE
The price that a stock is sold short for must be higher than the
price that was previously in effect. For example, if a stock was trading at
$25, and has advanced to $25.125, it can be sold short at $25.125. OTOH, if
a stock was trading at $25.125 and has just dropped to $25, no short sale
orders will be accepted at $25. This rule was instituted to prevent large
investors from smashing a stock price by bombing the market with huge numbers of
borrowed shares all at once. The exchanges started following this rule
in the 1930s but NASDAQ did not start until the late 1990s. Note: diversified
baskets of stocks such as the S&P 500 Depositary Receipts (SPY) are exempted
from the uptick rule.

MARGIN RULES
You must have buying power in your account at least equal to the value
of the stock you are shorting. The buying power is extinguished by the
short sale. Proceeds of the short sale are placed in a special escrow account
cleverly called "the short account."

THE SHORT ACCOUNT
Once your order to sell short is filled, your broker creates a special
sub-account called the short account. This functions as an escrow
account to prove to the world that you always have the financial capability
to buy back the shares that you just borrowed and sold short. Proceeds from
the short sale are kept here, as are additional sums that will be called
from you if the share prices increase (see "MARKING TO MARKET" below).
The point that most beginners miss is that the money in the short account is **NEVER**
available for any investment (except buying back the shares you sold short).
Selling short does not increase the cash balance of your margin account.
It does not increase your buying power; in fact, it reduces it. The short
account balance is not really your money; you won't receive interest on it
unless you're so rich you can persuade your broker to pay you some for the
privilege of keeping your enormous business.)

MARKING TO MARKET
After the short position is established, the value of the stock will
fluctuate from your sale price. In order to make sure that you are
always capable of buying it back, a process called "marking to market" is
carried out. Any increase in the value of the stock will result in a cash
transfer from your margin account to the short account of 100% of the
increase. This is real cash,not just a calculation. The actual cash balance
in your margin account will fall, or a debit balance will form if you are
out of cash. The buying power of your margin account also falls because this
cash is being removed. Conversely, if the value of the shorted stock
falls, cash will be transferred from the short account to your margin
account for 100% of the decline. (That is much more fun.)

DIVIDENDS
If the stock you sold short pays a dividend, you will be charged cash
to pay out this dividend. This is done to ensure that everybody who
buys shares receives their dividends.

WHEN YOU'RE EVEN, YOU'RE NOT
Let's suppose you took $20,000 and bought $20,000 of Longco and sold
short $20,000 of Shortco. (At this point, you would be at 50% equity
and have no buying power.) Let's also suppose that the values of both stocks
then increase to $25,000. You're even,right? The $5,000 gain on Longco
offsets the $5,000 loss on Shortco,right? Guess again. The short position
will be marked to market, showing a $5,000 loss, so $5,000 will be charged to your
margin account and sent over to the short account. You now have a debit balance
of $5,000 in your margin account. The equity in your margin account is still
$20,000 ($25,000 Longco - $5,000 debit). You have $50,000 of securities, so
you are now down to 40% equity. If both stocks continue to rise together you
will eventually get a margin call, even though there is no net trading loss.
Watch out for this.

CLOSING THE POSITION
To close the short position, place an order such as "Buy to cover 100
shares of XYZ". The words "to cover" alert your broker that you are closing a
short position and will not be an owner of the stock. There are no restrictions on buy orders. The funds to
purchase the stock will be drawn from your short account. If there are no more
short positions left open after this trade, the short account will vanish and
you are back to a plain margin account.

VOTING RIGHTS
The buyer of the borrowed shares gets voting rights, the lender
loses them. If you are a big enthusiast of voting in corporate elections,
you should keep your own shares in a cash account.

Thanks to Ron Forsch
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