Friday, March 12, 2010

Short Selling: An overview

Short selling, other wise as “going short”, or “shorting”, is a method of selling assets that has been borrowed from a third party, with the intention of buying identical assets back to return to the lender later. It is one of the many finance tricks people use to make money.

Short sellers wish to “sell high and buy low”, therefore profiting when the stock to go down instead of go up.

Here are the steps used by short sellers:

1. The short seller sells a security to a buyer, either on a virtual stock platform or in person. However, he does not possess the security he sold.

2. The short seller has three days (in US) to borrow a security from his broker, who in turn borrows it from an investor who is holding the security long, either in a mutual fund, pension fund, or other forms of long investment. During the three day period, some form of collateral is required for the initial short margin.

3. The short seller delivers the borrowed shares to the buyer.

4. Upon completion of the sell, the shorter can close the position by buying the shares and returning them to the lender, or keep staying short. However, the shorter must buy the shares and return it to the lender whenever the lender decides to sell the shares to someone else (otherwise known as “recall”). A “buy in” occurs when a broker does the purchase and return automatically.

Short selling, as can be interpreted from the above steps, can only occur if there is a ready supply of securities to borrow, and when the securities that are returned to the seller don’t have to be physically the same (ie. the same piece of paper) that is borrowed. The latter characteristic of securities is known as fungible.

A theoretical aspect of short selling involves the fact that the losses in short selling is unlimited while the gains are limited. This arises from the fact that a stock can’t fall below zero, so the maximum gain is the stock price when the position is opened per share. The stock, however, may go up in value indefinitely, perhaps forcing huge losses when the shorter has to buy back the stock at a much higher price.

Sometimes “shorting” is used as a blanket term for all strategies that allow the trader to take a bearish point of view (that is, for the trader to profit when the value of the asset involved goes down). For example, the concept in options known as puts, and to be short on a futures contract, are both described as “shorting”.

During “bubbles”, such as the Dot-com bubble, short sellers may sell hoping for a market correction. FDA announcements that cause an irrational growth are sometimes shorted when traders wait for the exaggerated reaction to subside.

If the seller fails to borrow the security from somewhere, a naked short occurs. This is illegal and is supposedly detected as a “fail to deliver” or “fail”, but systemic abuses arising from the fact that the stock market is dematerialized that involve turning over short positions to avoid T+3 detection is possible. This results in more shares turn up to vote in the annual general meeting than were issued, and may be used in a bear raid to bring down a stock. New regulations by the SEC were put in place to prevent widespread naked short, and more stringent measures were legislated in the stock market crash of 2008 to prevent exacerbation of market conditions.

Dividends are given to the new buyer of the stock, but the lender may be unaware that his shares are lent and will also expect a dividend. Therefore, the short seller has to pay the lender an amount equal to the dividend to compensate, and this is known as “short the dividend.”

Short selling had historically aroused much controversy and attack from political leaders, simply because that by speculating on a downward trend when a stock goes down, the seller sells more and causes the stock to go down more. A downward spiral results. The Wall Street crash of 1929, for example, was partly blamed on short sellers, and the congress enacted regulations to ban short selling stocks that are going down (known as the “uptick rule”). This ban was only lifted in July of 2007 (SEC Release No. 34-55970).

Short selling is viewed as contributing to unwanted market volatility, and in 2008 many financial companies in the US, UK, Australia, and Spain were prevented from shorting stocks when they stabilize the market.

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