Short Selling...What, When, Where, How
Shorting a stock, or short selling, means to sell a stock that
you do not actually have ownership of so you may profit from its
potential decline in price. The shares of the stock are borrowed
by your broker and then sold in the open market. The resulting
funds are deposited in your account. The hope is that you can by
them back later at a lower price in order to return them to
their rightful owner. When successful, this will allow you to
pocket the difference in price as a profit. In order to do this,
you must have a margin account with your broker and your broker
must have the shares available to loan to you. The number of
shares you can borrow is based on the cash already in your
account.
At first glance, the act of shorting a stock does not appear to
be much more complex than simply the reverse of buying a stock.
However, before you run out and start shorting stocks, let's
look at what else is involved and why shorting stocks is
generally considered more risky than going long. You should also
keep in mind that shorting stocks involves potentially unlimited
risk. This is because stocks can go higher with no limit, and if
you are short the shares you are on the hook. By contrast, when
going long, a stock can "only" go to zero.
As you will see by reading on, there are a number of differences
between shorting stocks and buying stocks that you should be
very aware of. Interestingly, each of these differences, when
taken separately, does not seem all that important. However,
when combined together, they can and do increase the risks
associated with shorting a stock; this is especially true should
things turn against you in the market.
Let's continue by examining some of the more important factors
to keep in mind when considering short selling: One of the first
questions that comes to mind when talking about shorting stocks
(i.e. selling borrowed stock to reap a profit by buying it back
at a lower price) is where does the initial stock actually come
from? This is a good question and one that often times comes
into play when attempting to short a stock in the first place.
The fact is, you have to be able to borrow the shares to begin
with to short a stock. However, sometimes this is actually not
always possible. When you place an order to short a specific
stock, a search is made to find available shares in the market.
Interestingly enough, shares are borrowed from other investors'
accounts without the knowledge of the original stockholder.
Firms usually search their own accounts first, then the accounts
of larger firms in an effort to find shares to short. The larger
the firm you deal with, the more luck you may have shorting the
stock you want.
Shorting shares of IBM, MMM or GE may not be much of a feat,
since stock is generally readily available in many accounts
across the country for these types of larger companies. When a
stock is widely held and quite liquid, more than likely shares
are available at the brokerage firm where you are placing your
order. However, should you suddenly try to short shares in a
stock which is more thinly traded or which is not as widely
held, you may run into more difficulty. In fact, often times you
simply cannot short certain stocks because no shares can be
found to borrow (note: sometimes providing your brokerage firm
with 24 hours notice on the stock(s) you wish to short can help
matters).
However, assuming there are shares available, your firm will
borrow the shares and allow you to sell them in the open market.
The resulting sale will leave you "short the stock" and you will
have the profits from the sale deposited into your account just
as with any other sale of stock. As mentioned, you must have
funds in your account in the first place in order to short
stocks, just as you would in order to purchase a stock. In other
words, you cannot wake up tomorrow morning and suddenly short 5
million shares of stock in CSCO without having an equal amount
of money to back up the sale.
What's the catch? The main stipulation here when shorting a
stock is that should those original shares suddenly be called
upon by the original owner (for example, to be sold), they must
immediately be returned and/or covered by the firm loaning out
the shares (and that means you really). If replacement shares
are not available, or a shortage in the shares occurs, you may
be faced with having the stock "called away" from you. When this
happens, the only recourse you may have is to buy the stock
[immediately] in the open market - regardless of price. As you
may be starting to see, shorting has aspects not normally
associated with buying stocks.
Aside from being unable to locate shares to short in the first
place, there are other cases in which you may find that you
cannot short a stock. Generally speaking, you cannot short most
IPO's, nor can you short stocks under $5 (however, as an
interesting side note, I believe in Canada you can short stocks
of any price). Typically, it's best to call ahead and make sure
there are shares available to short in the stock you are
interested in and that it meets all shorting guidelines for the
brokerage firm you are using.
The "Uptick"? Assuming you find shares to short, there are
certain rules which control the sale of the stock depending on
which exchange it trades upon. Generally speaking, you cannot
sell a stock into a falling market. This is where the "uptick"
rule comes into play. As you can probably imagine, this is done
to help keep short sellers from causing a sliding market where
nothing but selling is taking place. Normal selling is viewed
one way in the market, while short selling is viewed somewhat
differently.
Should you attempt to sell borrowed stock, you may find that you
have to wait for what is called an "uptick" in some cases. On
the NYSE exchange, this means that a short sale may only be done
on an uptick or a zero plus tick - a price that is the same
price as the last trade, but higher in price than the previous
different trade. On the Nasdaq exchange, you cannot short on the
bid side of the market when the current inside bid is lower than
the previous inside bid (a down tick). If you are shorting
stocks on other exchanges, you'll need to review the rules
associated with that exchange or ask your broker to explain what
is required for each individual situation. But, in general, you
can only short into a rising or stable market. Once the market
does up tick, you can then sell your stock at the current bid
price offered in the market. The profit resulting from the sale
is then deposited into your account.
One of the first differences you should note when shorting
stocks is the large additional upside risks which are involved.
When you buy a stock, the worst that can happen is the stock
will go to zero. However, when you short a stock, it can go up
forever. This is a very important point to consider before
shorting any stock, since the upside risks are basically
unlimited (although there are margin requirements that will
eventually kick in and result in a margin call).
Interestingly, there is a benefit to shorting stocks. Typically,
and this is only a guideline, stocks tends to fall about twice
as fast as they climb. As you know, negative news can bring down
a stock very quickly - sometimes wiping out months' worth of
gains in a single day or two. From this standpoint, if you do
hit a short play correctly, your gains can sometimes be realized
in a shorter time period than waiting for a stock to gain ground
and move higher.
Another aspect of shorting stocks that you should always keep in
mind, and which in some respects increases risk, is the idea of
"latent demand". When you short the stock, you actually are
building up latent demand for the shares. This is because at
some point in the future (unless the company goes out of
business) you will have to be a buyer of the stock in order to
return the shares to their rightful owner. A wave of short
sellers will one day mean a wave of buying.
If you have been trading stocks for any amount of time, you will
have probably heard the term "short squeeze". A short squeeze is
actually when there is a sudden demand (i.e. buying) in a stock
that has a large amount of shares outstanding on the short side.
If the buying keeps up and starts to force short players to
cover their short positions, the result can be quite severe.
Buying increases the share price, which in turn tends to produce
additional fear (and short covering) among short-side players in
the stock market. As people rush to buy stock and cover their
positions, this continues to dizzying heights until a normal
supply/demand situation returns to the market. As the old saying
goes, "He who sells what isn't his buys it back or goes to
Prison". The bottom line is that if the stock you have borrowed
and sold is suddenly required, you may end up being "bought in"
whether you like it or not.
Assuming everything goes as planned, then at some point you will
cover your short position to complete the trade. In order to
complete a short sale, you will need to repurchase and return
the borrowed shares of the stock. This is called "covering" your
short position and completes the transaction.
Incidentally, when placing your order, you should specifically
instruct your broker that you are covering an open short
position; otherwise it's possible to end up with both a long and
short position in play. Ideally, you'll be covering your short
play at a lower price than where you sold the shares and this
resulting difference in price will be your profit.
Finally, if you are short a stock at the same time as a stock
dividend is paid, don't forget that you owe that dividend to the
owner of the original stock. Your broker will charge your
account for the amount of the dividend owed based on the number
of shares you have borrowed. Keep this in mind when shorting
dividend-paying stocks.
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links included. Questions and comments can be sent to Ray at
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