Short Selling

I still remember when someone first asked me about short selling, and my response was: “What’s short selling?” Now I understand what it is and how it works, but I’ve never engaged in it. However, the market has been really bad lately, and being able to sell stocks short would provide an opportunity to profit or, at the least, balance out the (long) holdings that are dropping in value.

Most people buy stocks with cash. That is also known as going long or taking a long position. Owning 100 shares is the same thing as being long 100 shares. Short is the opposite. It doesn’t mean selling shares you own, it means owing shares to someone else. If I start with 0 shares and sell 100 shares, I am now short 100 shares. Going short is done to profit from overpriced shares that are expected to fall in value. Whereas a long position can be sold to take a profit (or a loss), a short position needs to be purchased to take a profit (or a loss).

Short sales are not available to every investor. An investor would require a margin account, where the broker agrees to lend the investor money, that is authorized for short selling. The investor will also need to sign a waiver, taking full responsibility for the greater risks inherent in borrowing money and shares. When the investor decides to sell shares that he doesn’t own, the trade needs to be clearly marked as a short sale. The broker then needs to borrow the shares, normally from another investor’s account in return for a small fee, and sell them in the market. To close the position, the investor would buy the shares in the market, ideally at a lower price, then return them to the broker, who will return them to the original account. If the shares the investor wants to sell short are not available to borrow from another investors account with the same broker, the broker will usually decline the transaction.

How much does it cost? I don’t have a very clear understanding of this, so feel free to clarify in the comments below. The first cost is the fee for borrowing shares. I believe this is low and is added into the trade commission. The next cost is margin. There are three categories of stock, those that are ineligible for margin, those that are eligible for 50% and those eligible for 30% reduced margin. When short selling, add 100% margin requirement. That means all the proceeds of the short sale are required for margin (ie. the cash cannot be used for other purposes), plus another 30% or 50% of margin is required. As an example, selling short 1000 shares of XYZ stock (eligible for 30% margin) at $10 each would produce $10,000 cash (less commissions). It would also require $13,000 margin. Therefore, $3000 margin is required before completing the short sale. Because cash is produced from the sale, some brokers will share the interest earned with the investor, but I notice that TD Waterhouse has a clear policy that they don’t do this. If XYZ pays any dividends during the period that the investor is short, the investor is also responsible to pay that dividend.

There are many ways that a short sale could go wrong. If the stock goes to zero, the amount of profit is limited. But if the price continues to rise (think AAPL), the amount of loss can be disproportionate. This is not a reward structure that I am comfortable with; I far prefer limited losses and limitless gains. In reality, losses cannot really be unlimited. If the share price rises, the investor will receive a margin call, at which point they may be required to close the position and book the loss. This is particularly likely during periods of high volatility. As the stock market rises, volatility tends to be lower; volatility rises as the stock market falls. This could mean being forced to purchase back the stock before it becomes a very profitable short sale. Another possibility is that the borrowed shares could be called back. If the investor who loaned out the shares wants to sell them (to close her long position), the shares need to be returned. The broker may be able to find another account to re-borrow the shares from, but there is no guarantee.

Just watching Sino-Forest and Yellow Media recently, along with the entire market sliding downward, has piqued my interest in being able to sell short. I won’t lay out the various strategies, but having a small portion of a portfolio short, with good judgement, could lead to similar profits with reduced volatility.