How Short Selling Works

Investment Snapshot

* In 1992, George Soros profited by $2 billion from selling short the British pound.
* Short selling allows hedge funds to profit during bear markets.
Most investors invest in common stocks by buying them and then selling them later. Outright ownership of shares is referred to as a long position. The opposite is a short position, which is based on the expectation that the price of the security will decline. A short position indicates that a security is borrowed and then sold and bought back in the future when the price declines. When stock prices are expected to increase, you can benefit from buying stocks. When stock prices are expected to decrease, you can benefit from selling short stocks before their prices decrease.

In a short sale, you borrow stocks to sell with the expectation that the prices of the stocks are going to decline. If the stock prices do decline, you can buy the stocks back at a lower price and then returned the borrowed shares to the lender. An example illustrates this process.

Ms. X thinks that the stock of Dell (the computer company), ticker symbol DELL, is overvalued and that its price will drop. She places an order with her broker to sell short 100 shares of Dell, which is transacted at $43 per share (the total proceeds are $4,300 without commissions). The brokerage firm has three business days to deliver 100 shares of Dell to the buyer and has several sources from which to borrow these securities. It might borrow the 100 shares of Dell from its own inventory of Dell stock, if it has any, or from another brokerage firm. The most likely source is from its own inventory of securities held in street name from its margin accounts. In this example, the brokerage firm locates 100 shares of Dell in a margin account belonging to Mr. Y. The brokerage firm sends these shares to the buyer, who bought the shares sold short by Ms. X, and Dell is notified of the new ownership.

All parties in this transaction are satisfied. The buyer has acquired the shares. The short seller, Ms. X, has $4,300, minus commissions, in her margin account, and the brokerage firm has received the commissions on the trade. The $4,300 (minus commissions) is held in the margin account (and cannot be withdrawn by Ms. X) as protection in case Ms. X defaults on the short sale. Mr. Y, who more than likely signed a loan consent form when he opened his margin account, is indifferent to the process. He still has all his rights of the ownership of the 100 shares of Dell. This process is illustrated in Figure 8–1.

When the stock in question is a dividend-paying stock, who receives the dividend? Before the short sale, the brokerage firm would have received the dividend on the 100 shares held in street name in Mr. Y’s margin account, and this amount would then be paid into his account. However, those shares have been used in the short sale and forwarded to the new buyer, who receives the dividend from the company. Mr. Y is still entitled to his dividend. The short seller, Ms. X, who borrowed his securities, must pay to Mr. Y an equal dividend amount via the brokerage firm.

Figure 8-1
A Short Sale

When Dell declines to $18 per share, Ms. X puts in a buy order to cover her short position. The securities are returned to the brokerage firm, and Ms. X has made a profit of $25 per share, not counting the commissions on the trades and the dividend.

Short sales are transacted in margin accounts. The possibility always exists that Ms. X could skip town, and then the brokerage firm would be short the 100 shares of Dell. By using a margin account, the short seller (Ms. X) has to leave the proceeds from the short sale in the account and is also required to pay in an additional amount of cash—that’s the margin requirement discussed in Chapter 7. Assuming a margin requirement of 50 percent, Table 8–1 illustrates Ms. X’s margin account.

Margin accounts provide greater leverage than cash accounts. Ms. X paid $2,125 and received a 111 percent return ($2,358/$2,125). Cash transactions require the entire investment in the stock to be put up in cash, which reduces the rate of return. Leverage is the creation of profit or loss proportionately greater than an underlying investment by using other people’s money. The use of leverage has the effect of a double-edged sword. In the event of losses, the percentage loss is greater on margin trading than on cash trades.

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