Smaller Thoughts

How to Sell Short

Perhaps you’ve seen headlines or references in articles about the ban on short selling. Many believe it is one of the main causes of the current financial crisis and the fall of such banks as Bear, Lehman, and AIG. But what exactly is “short selling?” How and when can you do it? And why is it so frowned upon?

When to Sell Short: You sell short when you think that a certain stock price is going to fall, and you’d like to profit off of that premonition.

How to sell short: Say you know something about a certain stock that nobody else does. Let’s use Apple. You were a tester for the new iPhone which you found malfunctioned. You know that upon release of the phone tomorrow, Apple’s stock price will fall. You want to profit off of this, but you don’t own any AAPL shares. Or you do, but not as many as you’d like.

So you borrow AAPL stock from someone else’s account. Let’s call him Joe. Your broker can help you do this – take 100 AAPL shares out of his client, Joe’s, account (without Joe knowing about it) and give them to you. You sell those 100 shares at $140.90 each, today’s share price. The next day the new iPhone comes out, it bombs, and as you thought, shares fall to $100. (Dramatic, yes, but go with it). The next week, you think Apple’s share price will rise, so you buy back those 100 shares at $100 and give them back to Joe’s account. You’ve just made a sweet $4,090 in profit. To sum it up: you borrow shares of stock from someone else’s account. Sell them. Then buy them back at a (hopefully) lower price and return them to the account from which you borrowed.

Why sell short. One reason, as described above, is to speculate. If you think a stock or the market as a whole is overpriced, you can make money off of it. A second reason is to hedge – to protect yourself from unexpected losses. That is, if you’re long AAPL but want to take a little less risk, you might short AAPL just in case the stock price declines.

Don’t sell short. Now I’m not recommending you actually do this, unless you are well versed in the markets. It’s pretty risky. If Joe decides he wants to do something with these shares, he can call you on it. At that moment you’ll have to cover, which means you’ll have to buy back the shares you borrowed from him and put them back into his account. So – say AAPL price actually rose and you were called when it was $160.90. Then you would have lost $2,000.

Can’t sell short. I also don’t recommend you do this, because right now you can’t. The SEC just put a ban on short-selling. After allegations that short sellers have led to the failures of Lehman, Bear, and the like, the SEC stepped in on Thursday and issued a temporary ban on short selling for 799 financial stocks. It’s alleged that short sellers often use false information and conspire to drive down the price of the stock.

This isn’t the first time we’ve placed a ban on short sellers. Short sellers were blamed for the Wall Street crash of 1929. Congress reacted by enacting a law, referred to as the “uptick rule,” which banned sellers from shorting during a downturn. Sellers could not short a share when the stock was selling for lower than the previous trade. This kept short sellers from adding downward momentum of a stock when it was already declining. After almost 80 years, the ban was lifted in 2007, when the SEC determined the markets were orderly enough that they didn’t need the restriction (this is despite the fact that just two years prior in 2005, the SEC sought to restrict short-selling outright).

The history of short-selling takes us back earlier than the Great Depression, however. In 1609, Isaac Le Maire, a Dutch trader, made the first short. He was concerned about threats of attack by English ships and shorted shares of the Dutch East India Company, the first multinational corporation and the first company to issue stock. The Dutch stock exchange did not approve of Le Maire’s actions and temporarily banned short-selling.

Later, during the Dutch depression of the 1630s, speculators saw short-selling as a means to profit off of the economic downturn. The English reacted by banning short-selling completely at the time.

A decent primer, but a couple clarifications:

Don’t short a stock to hedge your exposure in that stock - it doesn’t make sense, as you are effectively cancelling out your long position. If you are long one share and short one share, you make zero profit no matter how the stock moves. In fact, you’d lose money no matter what, because of transaction costs (broker fees). If you are currently long a stock, and want to reduce your exposure, just sell some of your shares.

Short positions are used to hedge in the following manner: if you are long AAPL, you might short an ETF that tracked the personal computer industry. This is because you have multiple types of risk embedded in your AAPL holding - risk inherent to Apple, and systemic risk across the personal computer industry. By shorting the personal computer ETF, you have eliminated your risk associated with the industry Apple operates in, leaving you only with the risk associated with Apple, the company, specifically.

Also, usually you won’t be called on your short position. If Joe wants his shares back, your broker will just arrange to borrow them from somebody elses account.

Dihard - definitely enjoying your financial posts as of late though…

Source: dihard