Short selling basics

Short selling (also known as “shorting,” “selling short” or “going short”) refers to the sale of a security or financial instrument that the seller has borrowed to make the short sale. The short seller believes that the borrowed security's price will decline, enabling it to be bought back at a lower price. The difference between the price at which the security was sold short and the price at which it was purchased represents the short seller’s profit (or loss, as the case may be).

Short selling is perhaps one of the most misunderstood topics in the realm of investing. In fact, short sellers are often reviled as callous individuals who are only out for financial gain at any cost, without regard for the companies and livelihoods destroyed in the short-selling process. The reality, however, is quite different. Far from being cynics who try to impede people from achieving financial success – or in the U.S., attaining the “American Dream” – short sellers enable the markets to function smoothly by providing liquidity and also serve as a restraining influence on investors’ over-exuberance.

Excessive optimism often drives stocks up to lofty levels, especially at market peaks (case in point – dotcoms and technology stocks in the late 1990s, and on a lesser scale, commodity and energy stocks from 2003 to 2007). Short selling acts as a reality check that prevents stocks from being bid up to ridiculous heights during such times.

While “shorting” is fundamentally a risky activity since it goes against the long-term upward trend of the markets, it is especially perilous when markets are surging. Short sellers confronted with escalating losses in a relentless bull market are painfully reminded of John Maynard Keynes’ famous adage: "The market can stay irrational longer than you can stay solvent."

Although short selling attracts its share of unscrupulous operators who may resort to unethical tactics – which have colorful names such as “short and distort” or "bear raid" – to drive down the price of a stock, this is not very different from stock touts who use rumors and hype in "pump-and-dump" schemes to drive up a stock. Short selling has arguably gained more respectability in recent years with the involvement of hedge funds, quant funds and other institutional investors on the short side. The eruption of two savage global bear markets within the first decade of this millennium has also increased the willingness of investors to learn about short selling as a tool for hedging portfolio risk.

Short selling can provide some defense against financial fraud by exposing companies that have fraudulently attempted to inflate their performances. Short sellers generally do their homework very well, thoroughly researching before adopting a short position. Such research often brings to light information not readily available elsewhere, and certainly not commonly available from brokerage houses that prefer to issue buy rather than sell recommendations.

Overall, short selling is simply another way for stock investors to seek profits honestly.

Let’s use a basic example to demonstrate the short-selling process.

For starters, you would need a margin account at a brokerage firm to short a stock. You would then have to fund this account with a certain amount of margin. The standard margin requirement is 150%, which means that you have to come up with 50% of the proceeds that would accrue to you from shorting a stock. So if you want to short sell 100 shares of a stock trading at $10, you have to put in $500 as margin in your account.

Let’s say you have opened a margin account and are now looking for a suitable short-selling candidate. You decide that Conundrum Co. (fictional company) is poised for a substantial decline, and decide to short 100 shares at $50 per share.

Here is how the short sale process works:

1. You place the short sale order through your online brokerage account or financial advisor. Note that you have to declare the short sale as such, since an undeclared short sale amounts to a violation of securities laws.

2. Your broker will attempt to borrow the shares from a number of sources, including the brokerage's inventory, from the margin accounts of one of its clients or from another broker-dealer. Regulation SHO released by the SEC in 2005 requires a broker-dealer to have reasonable grounds to believe that the security can be borrowed (so that it can be delivered to the buyer on the date that delivery is due) before effecting a short sale in any security; this is known as the “locate” requirement.

3. Once the shares have been borrowed or “located” by the broker-dealer, they will be sold in the market and the proceeds deposited in your margin account.

Your margin account now has $7,500 in it; $5,000 from the short sale of 100 shares of Conundrum at $50, plus $2,500 (50% of $5,000) as your margin deposit.

Let’s say that after a month, Conundrum is trading at $40. You therefore buy back the 100 Conundrum shares that were sold short at $40, for an outlay of $4,000. Your gross profit (ignoring costs and commissions for simplicity) is therefore $1,000 ($5,000 - $4,000).

On the other hand, suppose Conundrum does not decline as you had expected but instead surges to $70. Your loss in this case is $2,000 ($5,000 - $7,000).

A short sale can be regarded as the mirror image of "going long," or buying a stock. In the above example, the other side of your short sale transaction would have been taken by a buyer of Conundrum Co. Your short position of 100 shares in the company is offset by the buyer’s long position of 100 shares. The stock buyer, of course, has a risk-reward payoff that is the polar opposite of the short seller’s payoff. In the first scenario, while the short seller has a profit of $1,000 from a decline in the stock, the stock buyer has a loss of the same amount. In the second scenario where the stock advances, the short seller has a loss of $2,000, which is equal to the gain recorded by the buyer.

• Hedge funds are one of the most active entities involved in shorting activity. Most hedge funds try to hedge market risk by selling short stocks or sectors that they consider overvalued.
• Sophisticated investors are also involved in short selling, either to hedge market risk or simply for speculation.
• Speculators account for a significant share of short activity.
• Day traders are another key segment of the short side. Short selling is ideal for very short-term traders who have the wherewithal to keep a close eye on their trading positions, as well as the trading experience to make quick trading decisions.

Short selling was synonymous with the "uptick rule" for almost 70 years in the United States. Implemented by the SEC in 1938, the rule required every short sale transaction to be entered into at a price that was higher than the previous traded price, or on an uptick. The rule was designed to prevent short sellers from exacerbating the downward momentum in a stock when it is already declining.

The uptick rule was repealed by the SEC in July 2007; a number of market experts believe this repeal contributed to the ferocious bear market and market volatility of 2008-09. In 2010, the SEC adopted an "alternative uptick rule" that restricts short selling when a stock has dropped at least 10% in one day.

In January 2005, the SEC implemented Regulation SHO, which updated short-sale regulations that had been essentially unchanged since 1938. Regulation SHO specifically sought to curb "naked" short selling (in which the seller does not borrow or arrange to borrow the shorted security), which had been rampant in the 2000-02 bear market, by imposing "locate" and "close-out" requirements for short sales.

Short selling involves a number of risks, including the following:

• Skewed risk-reward payoff. Unlike a long position in a security, where the loss is limited to the amount invested in the security and the potential profit is boundless (in theory at least), a short sale carries the theoretical risk of infinite loss, while the maximum gain – which would occur if the stock drops to zero – is limited.
• Shorting is expensive. Short selling involves a number of costs over and above trading commissions. A significant cost is associated with borrowing shares to short, in addition to interest that is normally payable on a margin account. The short seller is also on the hook for dividend payments made by the stock that has been shorted.
• Going against the grain. As noted earlier, short selling goes against the entrenched upward trend of the markets.
• Timing is everything. The timing of the short sale is critical, since initiating a short sale at the wrong time can be a recipe for disaster.
• Regulatory and other risks. Regulators occasionally impose bans on short sales because of market conditions; this may trigger a spike in the markets, forcing the short seller to cover positions at a big loss. Stocks that are heavily shorted also have a risk of "buy in," which refers to the closing out of a short position by a broker-dealer if the stock is very hard to borrow and its lenders are demanding it back.

Given these risks, why bother to short? Because stocks and markets often decline much faster than they rise.

For example, the S&P 500 doubled over a five-year period from 2002 to 2007, but then plunged 55% in less than 18 months, from October 2007 to March 2009. Astute investors who were short the market during this plunge made windfall profits from their short positions.

Short selling is a relatively advanced strategy best suited for sophisticated investors or traders who are familiar with the risks of shorting and the regulations involved. The average investor may be better served by using put options to hedge downside risk or to speculate on a decline because of the limited risk involved. But for those who know how to use it effectively, short selling can be a potent weapon in one’s investing arsenal.