Short Selling Tutorial

By Brigitte Yuille

http://www.investopedia.com/university/shortselling/
Thanks very much for downloading the printable version of this tutorial.
As always, we welcome any feedback or suggestions.
http://www.investopedia.com/contact.aspx

Table of Contents
1) Short Selling: Introduction
2) Short Selling: What is Short Selling?
3) Short Selling: Why Short?
4) Short Selling: The Transaction
5) Short Selling: The Risks
6) Short Selling: Ethics and the Role of Short Selling
7) Short Selling: Conclusion

Introduction
Have you ever been absolutely sure that a stock was going to decline and
wanted to profit from its regrettable demise? Have you ever wished that you
could see your portfolio increase in value during a bear market? Both scenarios
are possible. Many investors make money on a decline in an individual stock or
during a bear market, thanks to an investing technique called short selling. (For
related reading, see When To Short A Stock.)
Short selling is not complex, but it's a concept that many investors have trouble
understanding. In general, people think of investing as buying an asset, holding it
while it appreciates in value, and then eventually selling to make a profit.
Shorting is the opposite: an investor makes money only when a shorted security
falls in value.
Short selling involves many unique risks and pitfalls to be wary of. The
mechanics of a short sale are relatively complicated compared to a normal
transaction. As always, the investor faces high risks for potentially high returns.

This tutorial can be found at: http://www.investopedia.com/university/shortselling/

(Page 1 of 10)
Copyright 2010, Investopedia.com - All rights reserved.

Investopedia.com the resource for investing and personal finance education.

It's essential that you understand how the whole process works before you get
involved.

What Is Short Selling?

First, let's describe what short selling means when you purchase shares of stock.
In purchasing stocks, you buy a piece of ownership in the company. The buying
and selling of stocks can occur with a stock broker or directly from the
company. Brokers are most commonly used. They serve as an intermediary
between the investor and the seller and often charge a fee for their services.
When using a broker, you will need to set up an account. The account that's set
up is either a cash account or a margin account. A cash account requires that
you pay for your stock when you make the purchase, but with a margin account
the broker lends you a portion of the funds at the time of purchase and the
security acts as collateral.
When an investor goes long on an investment, it means that he or she has
bought a stock believing its price will rise in the future. Conversely, when an
investor goes short, he or she is anticipating a decrease in share price.
Short selling is the selling of a stock that the seller doesn't own. More specifically,
a short sale is the sale of a security that isn't owned by the seller, but that is
promised to be delivered. That may sound confusing, but it's actually a simple
concept. (To learn more, read Benefit From Borrowed Securities.)
Still with us? Here's the skinny: when you short sell a stock, your broker will lend
it to you. The stock will come from the brokerage's own inventory, from another
one of the firm's customers, or from another brokerage firm. The shares are sold
and the proceeds are credited to your account. Sooner or later, you must "close"
the short by buying back the same number of shares (called covering) and
returning them to your broker. If the price drops, you can buy back the stock at
the lower price and make a profit on the difference. If the price of the stock rises,
you have to buy it back at the higher price, and you lose money.
Most of the time, you can hold a short for as long as you want, although interest
is charged on margin accounts, so keeping a short sale open for a long time will
cost more However, you can be forced to cover if the lender wants the stock you
borrowed back. Brokerages can't sell what they don't have, so yours will either
have to come up with new shares to borrow, or you'll have to cover. This is
known as being called away. It doesn't happen often, but is possible if many
investors are short selling a particular security.

This tutorial can be found at: http://www.investopedia.com/university/shortselling/

(Page 2 of 10)
Copyright 2010, Investopedia.com - All rights reserved.

Investopedia.com the resource for investing and personal finance education.

Because you don't own the stock you're short selling (you borrowed and then
sold it), you must pay the lender of the stock any dividends or rights declared
during the course of the loan. If the stock splits during the course of your short,
you'll owe twice the number of shares at half the price. (To learn more about
stock splits, read Understanding Stock Splits.)

Why Short?
Generally, the two main reasons to short are to either speculate or to hedge.
Speculate
When you speculate, you are watching for fluctuations in the market in order to
quickly make a big profit off of a high-risk investment. Speculation has been
perceived negatively because it has been likened to gambling. However,
speculation involves a calculated assessment of the markets and taking risks
where the odds appear to be in your favor. Speculating differs from hedging
because speculators deliberately assume risk, whereas hedgers seek to mitigate
or reduce it. (For more insight, see What is the difference between hedging and
speculation?)
Speculators can assume a high loss if they use the wrong strategies at the wrong
time, but they can also see high rewards. Probably the most famous example of
this was when George Soros "broke the Bank of England" in 1992. He risked $10
billion that the British pound would fall and he was right. The following night,
Soros made $1 billion from the trade. His profit eventually reached almost $2
billion. (For more on this trade, see The Greatest Currency Trades Ever Made.)
Speculators can benefit the market because they increase trading volume,
assume risk and add market liquidity. However, high amounts of speculative
purchases can contribute to an economic bubble and/or a stock market crash.
Hedge
For reasons we'll discuss later, very few sophisticated money managers short as
an active investing strategy (unlike Soros). The majority of investors use shorts to
hedge. This means they are protecting other long positions with offsetting short
positions.
Hedging can be a benefit because you're insuring your stock against risk, but it
can also be expensive and a basis risk can occur. (To learn more about hedging,
read A Beginner's Guide To Hedging.)

This tutorial can be found at: http://www.investopedia.com/university/shortselling/

(Page 3 of 10)
Copyright 2010, Investopedia.com - All rights reserved.

Investopedia.com the resource for investing and personal finance education.

Restrictions
Many restrictions have been placed on the size, price and types of stocks traders
are able to short sell. For example, penny stocks cannot be sold short, and most
short sales need to be done in round lots. The Securities Exchange Commission
(SEC) has these restrictions in place to prevent the manipulation of stock prices.
As of January 2005, short sellers were also required to comply with the rules set
in place by "Regulation SHO", which modernized the rules overseeing short
selling and aimed to provide safeguards against "naked short selling." For
instance, sellers had needed to show that they could locate and get the securities
they intended to short. The regulation also created a list of securities showing a
high level of persistent sales to deliver.
In July of 2007, the SEC eliminated the uptick, or zero plus tick, rule. This rule
required that every short sale transaction be entered at a higher price than that of
the previous trade and kept short sellers from adding to the downward
momentum of an asset when it was already experiencing sharp declines. The
rule has been around since the creation of the SEC in 1934. One of the reasons
it was put in place was to slow rapid and sudden declines in share prices that can
occur as a result of short selling.
In July of 2008, the SEC used its emergency powers to put an end to market
manipulations, such as spreading negative rumors about a company's
performance and sharp price declines. The markets had been volatile as a result
of the of mortgage and credit crisis, and the SEC wanted to establish a renewed
confidence. For a month, it didn't allow naked short selling on the stocks of 19
major investment and commercial banks, which included the mortgage finance
companies Fannie Mae and Freddie Mac. (To learn more, read The Uptick Rule:
Does It Keep Bear Markets Ticking?)
The SEC took further measures in September of 2008, once again using its
emergency authority to issue six orders to minimize abuses. This included a
move to halt short selling in shares of 799 companies in cooperation with the
United Kingdom's Financial Service Authority. 170 companies were later included
in the ban, which ended after the passage of the $700 billion U.S. bailout plan in
October 2008. Another order required short sellers get a sale and immediately
close it by making sure the shares were delivered. It later became a rule.
Who Shorts?
Some insiders indicate that it takes a certain type of person to short stocks.
Many short sellers have been depicted as pessimists who are rooting for a
company's failure, but they've also been described as disciplined and confident in
their judgment. (To learn more, read Questioning The Virtue Of A Short Sale.)
This tutorial can be found at: http://www.investopedia.com/university/shortselling/
(Page 4 of 10)
Copyright 2010, Investopedia.com - All rights reserved.

Investopedia.com the resource for investing and personal finance education.

Sellers are typically:

wealthy sophisticated investors

hedge funds
large institutions
day traders

Short selling isn't for everyone. It involves a great amount of time and dedication.
Short sellers need to be informed, skilled and experienced investors in order to
succeed.
They must know:

how securities markets work

trading techniques and strategies
market trends
the firm's business operations

The Transaction
Suppose that, after hours of painstaking research and analysis, you decide that
company XYZ is dead in the water. The stock is currently trading at $65, but you
predict it will trade much lower in the coming months. In order to capitalize on the
decline, you decide to short sell shares of XYZ stock. Let's take a look at how this
transaction would unfold.
Step 1: Set up a margin account. Remember, this account allows you to borrow
money from the brokerage firm using your investment as collateral.
Step 2: Place your order by calling up the broker or entering the trade online.
Most online brokerages will have a check box that says "short sale" and "buy to
cover." In this case, you decide to put in your order to short 100 shares.
Step 3: The broker, depending on availability, borrows the shares. According to
the SEC, the shares the firm borrows can come from:

the brokerage firm's own inventory

the margin account of one of the firm's clients
another brokerage firm

This tutorial can be found at: http://www.investopedia.com/university/shortselling/

(Page 5 of 10)
Copyright 2010, Investopedia.com - All rights reserved.

Investopedia.com the resource for investing and personal finance education.

You should also be mindful of the margin rules and know that fees and charges
can apply. For instance, if the stock has a dividend, you need to pay the person
or firm making that loan. (To learn more, read the Margin Trading tutorial.)
Step 4: The broker sells the shares in the open market. The profits of the sale
are then put into your margin account.
One of two things can happen in the coming months:

The Stock Price Sinks (stock goes to $40)

Borrowed 100 shares of XYZ at $65
Bought Back 100 shares of XYZ at $40
Your Profit

$6,500
-$4,000
$2,500

The Stock Price Rises (stock goes to $90)

Borrowed 100 shares of XYZ at $65
Bought Back 100 shares of XYZ at $90
Your Profit

$6,500
-$9,000
-$2,500

Clearly, short selling can be profitable. But then, there's no guarantee that the
price of a stock will go the way you expect it to (just as with buying long).
Shorter sellers use an endless number of metrics and ratios to find shortable
candidates. Some use a similar stock picking methodology to the longs, but just
short the stocks that come out worst. Others look for insider trading, changes in
accounting policy, or bubbles waiting to pop.
One indicator specific to shorts that is worth mentioning is short interest. Short
interest is the total number of stocks, securities or commodity shares in an
account or in the markets that have been sold short, but haven't been
repurchased in order to close the short position. It serves as a barometer for a
bearish or bullish market. For instance, the higher the short interest, the more
people will anticipate a downturn. (For more insight, read Short Interest: What It
Tells Us.)

This tutorial can be found at: http://www.investopedia.com/university/shortselling/

(Page 6 of 10)
Copyright 2010, Investopedia.com - All rights reserved.

Investopedia.com the resource for investing and personal finance education.

The Risks
Now that we've introduced short selling, let's make one thing clear: shorting is
risky. Actually, we'll rephrase that. Shorting is very, very risky. It's not unlike
running with the bulls in Spain: you can either have a great time, or you can get
trampled.
You can think of the outcome of a short sale as basically the opposite of a
regular buy transaction, but the mechanics behind a short sale result in some
unique risks.
1. Short selling is a gamble. History has shown that, in general, stocks
have an upward drift. Over the long run, most stocks appreciate in price.
For that matter, even if a company barely improves over the years,
inflation should drive its stock price up somewhat. What this means is that
shorting is betting against the overall direction of the market.
So, if the direction is generally upward, keeping a short position open for a
long period can become very risky. (To learn more, read Stocks Are No.1
and The Stock Market: A Look Back.)
2. Losses can be infinite. When you short sell, your losses can be infinite.
A short sale loses when the stock price rises and a stock is (theoretically,
at least) not limited in how high it can go. For example, if you short 100
shares at $65 each hoping to make a profit but the shares increase to $90
apiece, you end up losing $2,500. On the other hand, a stock can't go
below 0, so your upside is limited. Bottom line: you can lose more than
you initially invest, but the best you can earn is a 100% gain if a company
goes out of business and the stock loses its entire value.
3. Shorting stocks involves using borrowed money. This is known as
margin trading. When short selling, you open a margin account, which
allows you to borrow money from the brokerage firm using your
investment as collateral. Just as when you go long on margin, it's easy for
losses to get out of hand because you must meet the minimum
maintenance requirement of 25%. If your account slips below this, you'll
be subject to a margin call, and you'll be forced to put in more cash or
liquidate your position. (We won't cover margin in detail here, but you can
read more in our Margin Trading tutorial.)
4. Short squeezes can wring the profit out of your investment. When
stock prices go up short seller losses get higher, as sellers rush to buy the
stock to cover their positions. This rush creates a high demand for the
stock quickly driving up the price even further. This phenomenon is known

This tutorial can be found at: http://www.investopedia.com/university/shortselling/

(Page 7 of 10)
Copyright 2010, Investopedia.com - All rights reserved.

Investopedia.com the resource for investing and personal finance education.

as a short squeeze. Usually, news in the market will trigger a short

squeeze, but sometimes traders who notice a large number of shorts in a
stock will attempt to induce one. This is why it's not a good idea to short a
stock with high short interest. A short squeeze is a great way to lose a lot
of money extremely fast. (To learn more, see Short Squeeze The Last
Drop Of Profit From Market Moves.)
5. Even if you're right, it could be at the wrong time. The final and largest
complication is being right too soon. Even though a company is
overvalued, it could conceivably take a while to come back down. In the
meantime, you are vulnerable to interest, margin calls and being called
away. Academics and traders alike have tried for years to come up with
explanations as to why a stock's market price varies from its intrinsic
value. They have yet to come up with a model that works all the time, and
probably never will.
Take the dotcom bubble, for example. Sure, you could have made a killing
if you shorted at the market top in the beginning of 2000, but many
believed that stocks were grossly overvalued even a year earlier. You'd be
in the poorhouse now if you had shorted the Nasdaq in 1999! That's when
the Nasdaq was up 86%, although two-thirds of the stocks declined. This
is contrary to the popular belief that pre-1999 valuations more accurately
reflected the Nasdaq. However, it wasn't until three years later, in 2002,
that the Nasdaq returned to 1999 levels.

Momentum is a funny thing. Whether in physics or the stock market, it's

something you don't want to stand in front of. All it takes is one big shorting
mistake to kill you. Just as you wouldn't jump in front of a pack of stampeding
bulls, don't fight against the trend of a hot stock.

Ethics And The Role Of Short Selling

It's safe to say that short sellers aren't the most popular people on Wall Street.
Many investors see short selling as "un-American" and "betting against the home
team" because these sellers are perceived to seek out troubled companies.
Some critics even believe that short sales are a major cause of market
downturns, such as the crash in 1987. There isn't a whole lot of evidence to
support this, as other factors such as derivatives and program trading also
played a massive role, but two years after the crash, the U.S. government held
the 1989 House subcommittee hearing on short selling. Lawmakers wanted to
This tutorial can be found at: http://www.investopedia.com/university/shortselling/
(Page 8 of 10)
Copyright 2010, Investopedia.com - All rights reserved.

Investopedia.com the resource for investing and personal finance education.

look at the effects short sellers had on small companies and examined the need
for regulation after allegations of widespread manipulation by short sellers of
over-the-counter stocks. SEC officials reassured the public that manipulations
hadn't been uncovered and more rules would be put in place. (To learn more,
read Questioning The Virtue Of A Short Sale and The Uptick Rule: Does It Keep
Bear Markets Ticking?)
But despite its critics, it's tough to deny that short selling makes an important
contribution to the market by:

Adding liquidity to share transactions. The additional buying and selling

reduces the difference between the price at which shares can be bought
and sold.
Driving down overpriced securities by lowering the cost to execute a trade
Increasing the overall efficiency of the markets by quickening price
adjustments
Acting as the first line of defense against financial fraud. For instance, in
2001, famed short seller James Chanos identified fraudulent accounting
practices that occurred with the Enron Corporation, an energy-trading and
utilities company. The company's activity became known as the Enron
scandal when the company was found to have inflated its revenues. It filed
Chapter 11 bankruptcy at the end of 2001. (To learn more about this
scandal, see The Biggest Stock Scams Of All Time.)

While the conflicts of interest from investment banking keep some analysts from
giving completely unbiased research, work from short sellers is often regarded as
being some of the most detailed and highest quality research in the market. It's
been said that short sellers actually prevent crashes because they provide a
voice of reason during raging bull markets.
However, short selling also has a dark side, courtesy of a small number of
traders who are not above using unethical tactics to make a profit. Sometimes
referred to as the "short and distort," this technique takes place when traders
manipulate stock prices in a bear market by taking short positions and then using
a smear campaign to drive down the target stocks. This is the mirror version of
the pump and dump, where crooks buy stock (take a long position) and issue
false information that causes the target stock's price to increase. Short selling
abuse like this has grown along with internet trading and the growing trend of
small investors and online trading. (For more insight, read The Short And Distort:
Stock Manipulation In A Bear Market.)

This tutorial can be found at: http://www.investopedia.com/university/shortselling/

(Page 9 of 10)
Copyright 2010, Investopedia.com - All rights reserved.

Investopedia.com the resource for investing and personal finance education.

Conclusion
Short selling is another technique you can add to your trading toolbox. That is, if
it fits with your risk tolerance and investing style. Short selling provides a sizable
opportunity with a hefty dose of risk. We hope this tutorial has enabled you to
understand whether it's something you would like to pursue. Let's recap:

In a short sale, an investor borrows shares, sells them and must

eventually return the same shares (cover). Profit (or loss) is made on the
difference between the price at which the shares are borrowed compared
to when they are returned.
An investor makes money only when a shorted security falls in value.
Short selling is done on margin, and so is subject to the rules of margin
trading.
The shorter must pay the lender any dividends or rights declared during
the course of the loan.
The two reasons for shorting are to speculate and to hedge.
There are restrictions as to what stocks can be shorted and when a short
can be carried out (uptick rule).
Short interest tells us the number of shares that have already been sold
short in a security.
Short selling is very risky. You can lose more money than you invest but
are limited to 100% profit on the upside.
A short squeeze is when a large number of short sellers try to cover their
positions at the same time, driving up the price of a stock.
Even though a company is overvalued, it may take a long time for it to
come back down. Fighting the trend almost always leads to trouble.
Critics of short selling see it as unethical and bad for the market.
Short selling contributes to the market by providing liquidity, efficiency and
acting as a voice of reason in bull markets.
Some unethical traders spread false information in an attempt to drive the
price of a stock down and make a profit by selling short.

This tutorial can be found at: http://www.investopedia.com/university/shortselling/

(Page 10 of 10)
Copyright 2010, Investopedia.com - All rights reserved.