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| Short Sale |
What it is:
A short sale is a three-step trading strategy that seeks to capitalize on an
anticipated decline in the price of a security. First, arrangements are made to
borrow shares of the security, typically from a broker. Next, the investor will
sell the shares immediately in the open market with the intention of buying them
back at some point in the future. Finally, to complete the cycle, at a later
date he/she will repurchase the shares (hopefully at a lower price) and will
return them to the lender. In the end, the investor will pocket the difference
if the share price falls, but will of course incur a loss if it rises.
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How it Works/Example:
Mr. Johnson firmly believes that ABC Corp. stock is due to fall, so he calls his
broker to sell short 100 shares of the company.
Please note: According to SEC regulations, short trades can only be entered
while the stock price is moving higher (known as a plus tick) or remaining
steady after an earlier rise (known as a zero-plus tick). This safeguard has
been put in place to prevent short sellers from manipulatively driving down the
price of a security.
In this example, we will assume that Mr. Johnson places the trade, which is immediately executed, to sell short 100 shares of ABC Corp. at $25.00 per share. He will receive a cash inflow of $2,500 from this transaction.
Now let's assume that two weeks later, the price has indeed dropped, and that Mr. Johnson is able to buy back the shares (known as covering a short position) for $20.00 per share. In this transaction, he'll have to spend $2,000 to repurchase the shares. His profit on the trade will be $500 ($2,500 initial cash inflow minus an eventual $2,000 cash outflow). The other way to look at it is that he will have earned $5 per share on the trade, giving him a gain of $500 ($5 gain multiplied by 100 shares). Using this same calculation, we can see that if the shares had risen to $27.50 during his holding period, then he would have been responsible for a $250 loss (100 shares * $2.50/share).
Essentially, a short seller is still trying to do the same thing a regular
investor is -- buy low and sell high. However, the short seller is trying to
accomplish this in reverse order. In other words, he/she is trying to first
sell high and then buy low. The short sale strategy, which is the
opposite of entering a long position, is a risky one for a number of reasons.
These include the potential for a margin call, as well as theoretically
unlimited losses should the underlying stock rise instead of fall. A short
seller is not entitled to keep any dividends distributed while he/she has
shorted a stock.
When a large number of investors decide to short a particular stock, their collective actions can have a dramatic impact on the company's share price. An investor can quickly determine the percentage of a company's outstanding shares that are currently being sold short by checking the stock's "short interest." For example, a 10% short interest means that one of every ten outstanding shares is held short.
Often, market analysts or financial journalists will attribute a rise in a given stock, or occasionally even the broader markets, to "short covering." Eventually, all short sellers must close out their trades by repurchasing the underlying shares that they initially sold. If many of them begin to do this simultaneously, then the rush of buying orders can temporarily boost stock prices. This often occurs after the market has fallen steeply (as short sellers attempt to lock in gains) or while it is rising sharply (as short sellers try to prevent further losses).
Occasionally, a sharp rise in a particular stock can trigger a large number of short sellers to cover their positions all at once. This short covering can push the share price even higher, causing even more short sellers to cover their positions and cut their losses. In these cases, the stock is said to be caught in a "short squeeze." Volatile stocks with large short interest are particularly susceptible to this phenomenon, and prospective short sellers should be wary of it.
Though they are a small minority, a few investors actually own shares in the company they intend to short. This alternate strategy -- known as "shorting against the box" -- is typically used when an investor expects the price to fall, but does not yet want to close out his/her position by selling his/her current long positions.
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