
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is held in the margin account (and cannot be withdrawn by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.
Table 8-1
Margin Account Illustrating a Short Sale
Proceeds from short sale of 100 shares of DELL at $43 |
$4,300 |
Less commissions and fees |
(50) |
Net proceeds |
4,250 |
Add total margin requirement (50%) |
2,125 |
Balance |
6,375 |
Minus interest expense on borrowed funds |
(42) |
Net proceeds |
6,333 |
Cost to purchase 100 shares of DELL at $18 |
$1,800 |
Add commission |
50 |
Total cost |
1,850 |
Balance |
4,433 |
Less margin deposit |
2,125 |
Profit |
$2,358 |
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