Tuesday, November 08, 2005

Selling stocks short

I first became interested in investing when I attended college during the mid-1990s. I read such seminal classics as One Up On Wall Street and Beating the Street by legendary Fidelity mutual fund manager Peter Lynch. During the course of my recreational reading on the subject I learned all about long and short positions. A long position in a stock is one in which the investor owns the shares themselves. A short position, on the other hand, is one in which the investor borrows the shares from another investor and then sells them, making money if the shares drop in value.

Although the concept is not difficult to understand, I had to do some sleuthing on my own before I really figured out what takes place during a short sale, as I discuss below.

(1) The investor must initially instruct his brokerage house to sell short shares of a stock.

The investor can only sell stock short if the investor has a "margin" account. A margin account is one in which the investor can borrow against his current holdings to purchase addition shares of various securities and sell short. A "cash" account, on the other hand, does not permit such borrowing or selling short.

(2) The brokerage house borrows the shares from another investor's account.

This is the part that isn't straightforward. That is, why can a brokerage house borrow shares from another investor's account? The brokerage house can only borrow shares from another investor's account that are held in "street name," i.e., in the name of the brokerage house. Most stock purchased nowadays is held in street name. This makes it much easier to sell the shares. If the stock were held in the investor's name instead of in street name, the invesotr would have to physically deliver the corresponding stock certificates to the brokerage house before selling such shares. However, if held in street name, the shares are already at the brokerage house's disposal.

The reason why the actual borrowing takes place is because a settlement must occur three days after a trade is made. This is known as the "T+3" rule. That is, three business days after a trade is made, the seller must deliver the shares being sold and the buyer must deliver the corresponding money for the shares.

The investor from whom the shares are borrowed can still sell his shares, and the investor's will reacquire the shares and the short selling investor's brokerage house will borrow the shares from a different investor.

(3) The investor buys back the short shares to "cover" the position.

After selling shares short, the investor has to eventually repurchase the shares to close his position in that stock. An investor with a long position makes money by first buying shares at a low price and then sell the shares at a higher price. A short seller makes money, on the other hand, by first selling the shares and then buying back the shares at a lower price at a later date.

CAVEATS

There are some caveats to short selling. First, if the price of the shares sold short keeps rising the investor can quickly lose a lot of money. Second, the investor's short position may be closed at any time such as, e.g., if the investor loses too much on the position relative to the investor's other holdings in the account. The short position may also be closed if the investor from whom the shares were borrowed decides to sell and the shorting selling investor's broker cannot find another investor from whom to borrow the shares.

Anyone considering selling a stock short also needs to be aware that the investor is responsible for paying dividends to the investor from whom the shares were borrowed. For example, assume that investor A borrows 100 shares of MSFT from investor B, and then sells the 100 shares to investor C. In the event that MSFT declares a dividend, investor C will receive the dividend directly from MSFT. However, investor A will have to pay investor B an amount of money equal to the value of the declared dividend.

13 comments:

Anonymous said...

Good informative about the subject matter.Keep up the good work. U may want to blog more about derivatives, warrant and etc for beginner investors.

Anonymous said...

Hi, first of all.A good start for your blog.Do you have any email address( you better setup a new email to just for this blog to avoid spam) that so that we can discuss about the stock investing?

if you have a email, i will be glad to send you and email and maybe we can chat over the MSN or yahoo about stock investments?

Signed,
Curious Investor

Hans said...

Such a good way to learn.
Really attractive...
Do you know more about alternative investments?
I also learn Black & Scholes formula which is very complicated.Are U specialist?

Signed,
A Beginner.

Jim said...

I am a professional, but not in the fields of finance or investments. My knowledge base of investments has been acquired over years of following the markets for fun.

I have not yet invested in derivatives because I don't think I understand those investments well enough to put my money into them. I do know that some like 90 percent of all options expire worthless, so it can't be that easy.

If you would like see posts dedicated to certain stock market/investing topics, please leave a message and I will add a post if I think I know enough about the topic to provide useful information.

Thanks.

Anonymous said...

Any comments or discussion of naked short selling and the controversy surrounding that strategy?

anon

Curios said...

hi,

May be u can discuss about how an company's earnings can effects its stock? it is an interesting topic on how investor perception on these kind of market news

fullymubbed said...

"However, investor B will have to pay investor A an amount of money equal to the value of the declared dividend."

Is it investor B paying the dividend to investor A or the other way round? Why would B have to lose his dividend (by selling 100 shares to A) and also pay the 'lost' dividend to A, when A is the one who sells the shares bought from B to C? I just dont get it..please help

Jim said...

Thanks for the comment. You're correct, I did have it backwards. Investor A would have to pay the "lost dividend" to B, not the other way around. I corrected it in the post.

Anonymous said...

Let's say my online trading menu allows me to enter the price at which I want to sell short. What's to prevent me from selling short at double or triple the current market value, and then immediately cover?

- A newbie

Jim said...

That wouldn't work. Nobody is going to purchase shares from you at two or three times the current market value.

Nick G said...

Hi,

I was wondering what major international markets allow short selling. Do you know where I can find this information? If you could send any ideas to ng2166@columbia.edu, I would appreciate it. Thanks.

Jim said...

Nick G, look here on page 13 for a list of countries allowing short sales: http://www.qwafafew.org/?q=filestore/download/378

I'm not sure how accurate or comprehensive this list is.

Anonymous said...

Is there a list of stocks that can't be shorted or are all stocks able to be shorted?