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Short Selling: What is Short Selling?

The Basics
When an investor goes long on an investment, it means she has bought a stock believing
its price will rise in the future. Conversely, when an investor goes short, he 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.

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. However, you can be forced to
cover if the lender wants back the stock you borrowed. Brokerages can't sell what they don't
have, and 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 selling a particular security short.

Since you don't own the stock (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.

Also, because you are being loaned the stock, you are buying on margin. In fact, you have to
open a margin account to short stocks. Your broker will charge you interest on the loan and you
are subject to rules of margin trading.

Why Short?
There are two main motivations to short:

1. To speculate
The most obvious reason to short is to profit from an overpriced stock or market. 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.

2. To 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.

Restrictions
There are many restrictions on the size, price and types of stocks you are able to short sell. For
example, you can't short sell penny stocks and most short sales need to be done in round lots.

In addition, the SEC, NYSE and NASD have rules preventing short selling unless the last trade of
the stock is at the same or higher price (known as an uptick or zero plus tick). These rules exist
so that investors can't sell short in a declining market. Continuous short selling on a falling stock
will keep forcing it down, damaging the market further

Short Selling: 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. You decide to take the plunge and short 100 shares. The transaction is
straightforward--most online brokerages will have a check box that says "short sale" and "buy to
cover."

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 $6,500
Bought Back 100 shares of XYZ at $40 -$4,000
Your Profit $2,500

The Stock Price Rises


(stock goes to $90)
Borrowed 100 shares of XYZ at $65 $6,500
Bought Back 100 shares of XYZ at $90 -$9,000
Your Profit -$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 want (just as with buying long).

Shorters 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. This reveals how many
shares have already been sold short. It's a dangerous sign if too much stock is sold short before
you initiate a new short position. This is discussed in detail in our article, "Short Interest: What
Does It Tell Us?"

Short Selling: 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 ... not unlike running with the bulls in Spain. You can
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 result in some unique risks.

1. 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.

2. 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 on how high it can go. 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.

3. Shorting stocks involves using borrowed money, otherwise known as margin trading. 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--you'll be forced to put in more cash or liquidate your position. (As mentioned earlier,
we won't cover margin details here because we have an entire tutorial devoted to it.)

4. If a stock starts to rise and a large number of short sellers try to cover their positions at the
same time, it can quickly drive up the price even further. This phenomenon is known 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.

5. 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 dot-com 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 shorted the Nasdaq in 1999! 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.

Futures Fundamentals: Characteristics


Given the nature of the futures market, the calculation of profit and loss will be slightly different
than on a normal stock exchange. Let's take a look at the main concepts:

Margins
In the futures market, margin has a definition distinct from its definition in the stock market, where
margin is the use of borrowed money to purchase securities. In the futures market, margin refers
to the initial deposit of "good faith" made into an account in order to enter into a futures contract.
This margin is referred to as good faith because it is this money that is used to debit any day-to-
day losses.

When you open a futures contract, the futures exchange will state a minimum amount of money
that you must deposit into your account. This original deposit of money is called the initial margin.
When your contract is liquidated, you will be refunded the initial margin plus or minus any gains or
losses that occur over the span of the futures contract. In other words, the amount in your margin
account changes daily as the market fluctuates in relation to your futures contract. The minimum-
level margin is determined by the futures exchange and is usually 5% to 10% of the futures
contract. These predetermined initial margin amounts are continuously under review: at times of
high market volatility, initial margin requirements can be raised.

The initial margin is the minimum amount required to enter into a new futures contract, but the
maintenance margin is the lowest amount an account can reach before needing to be
replenished. For example, if your margin account drops to a certain level because of a series of
daily losses, brokers are required to make a margin call and request that you make an additional
deposit into your account to bring the margin back up to the initial amount.

Let's say that you had to deposit an initial margin of $1,000 on a contract and the maintenance
margin level is $500. A series of losses dropped the value of your account to $400. This would
then prompt the broker to make a margin call to you, requesting a deposit of at least an additional
$600 to bring the account back up to the initial margin level of $1,000.

Word to the wise: when a margin call is made, the funds usually have to be delivered
immediately. If they are not, the brokerage can have the right to liquidate your position completely
in order to make up for any losses it may have incurred on your behalf.

Leverage: The Double-Edged Sword


In the futures market, leverage refers to having control over large cash amounts of commodities
with comparatively small levels of capital. In other words, with a relatively small amount of cash,
you can enter into a futures contract that is worth much more than you initially have to pay
(deposit into your margin account). It is said that in the futures market, more than any other form
of investment, price changes are highly leveraged, meaning a small change in a futures price can
translate into a huge gain or loss.

Futures positions are highly leveraged because the initial margins that are set by the exchanges
are relatively small compared to the cash value of the contracts in question (which is part of the
reason why the futures market is useful but also very risky). The smaller the margin in relation to
the cash value of the futures contract, the higher the leverage. So for an initial margin of $5,000,
you may be able to enter into a long position in a futures contract for 30,000 pounds of coffee
valued at $50,000, which would be considered highly leveraged investments.

You already know that the futures market can be extremely risky and,therefore, not for the faint of
heart. This should become more obvious once you understand the arithmetic of leverage. Highly
leveraged investments can produce two results: great profits or greater losses.

As a result of leverage, if the price of the futures contract moves up even slightly, the profit gain
will be large in comparison to the initial margin. However, if the price just inches downwards, that
same high leverage will yield huge losses in comparison to the initial margin deposit. For
example, say that in anticipation of a rise in stock prices across the board, you buy a futures
contract with a margin deposit of $10,000, for an index currently standing at 1300. The value of
the contract is worth $250 times the index (e.g. $250 x 1300 = $325,000), meaning that for every
point gain or loss, $250 will be gained or lost.

If after a couple of months, the index realized a gain of 5%, this would mean the index gained 65
points to stand at 1365. In terms of money, this would mean that you as an investor earned a
profit of $16,250 (65 points x $250); a profit of 162%!

On the other hand, if the index declined 5%, it would result in a monetary loss of $16,250 - a huge
amount compared to the initial margin deposit made to obtain the contract. This means you still
have to pay $6,250 out of your pocket to cover your losses. The fact that a small change of 5% to
the index could result in such a large profit or loss to the investor (sometimes even more than the
initial investment made) is the risky arithmetic of leverage. Consequently, while the value of a
commodity or a financial instrument may not exhibit very much price volatility, the same
percentage gains and losses are much more dramatic in futures contracts due to low margins and
high leverage.

Pricing and Limits


As we mentioned before, contracts in the futures market are a result of competitive price
discovery. Prices are quoted as they would be in the cash market: in dollars and cents or per unit
(gold ounces, bushels, barrels, index points, percentages and so on).

Prices on futures contracts, however, have a minimum amount that they can move. These
minimums are established by the futures exchanges and are known as “ticks.” For example, the
minimum sum that a bushel of grain can move upwards or downwards in a day is a quarter of one
U.S. cent. For futures investors, it's important to understand how the minimum price movement
for each commodity will affect the size of the contract in question. If you had a grain contract for
3,000 bushels, a minimum of $7.50 (0.25 cents x 3,000) could be gained or lost on that particular
contract in one day.

Futures prices also have a price change limit that determines the prices between which the
contracts can trade on a daily basis. The price change limit is added to and subtracted from the
previous day's close and the results remain the upper and lower price boundary for the day.

Say that the price change limit on silver per ounce is $0.25. Yesterday, the price per ounce
closed at $5. Today's upper price boundary for silver would be $5.25 and the lower boundary
would be $4.75. If at any moment during the day the price of futures contracts for silver reaches
either boundary, the exchange shuts down all trading of silver futures for the day. The next day,
the new boundaries are again calculated by adding and subtracting $0.25 to the previous day's
close. Each day the silver ounce could increase or decrease by $0.25 until an equilibrium price is
found. Because trading shuts down if prices reach their daily limits, there may be occasions when
it is NOT possible to liquidate an existing futures position at will.

The exchange can revise this price limit if it feels it's necessary. It's not uncommon for the
exchange to abolish daily price limits in the month that the contract expires (delivery or “spot”
month). This is because trading is often volatile during this month, as sellers and buyers try to
obtain the best price possible before the expiration of the contract.

In order to avoid any unfair advantages, the CTFC and the futures exchanges impose limits on
the total amount of contracts or units of a commodity in which any single person can invest.
These are known as position limits and they ensure that no one person can control the market
price for a particular commodity.

Futures Fundamentals: Strategies


Essentially, futures contracts try to predict what the value of an index or commodity will be at
some date in the future. Speculators in the futures market can use different strategies to take
advantage of rising and declining prices. The most common are known as going long, going
short and spreads.

Going Long
When an investor goes long - that is, enters a contract by agreeing to buy and receive delivery of
the underlying at a set price - it means that he or she is trying to profit from an anticipated future
price increase.

For example, let's say that, with an initial margin of $2,000 in June, Joe the speculator buys one
September contract of gold at $350 per ounce, for a total of 1,000 ounces or $350,000. By buying
in June, Joe is going long, with the expectation that the price of gold will rise by the time the
contract expires in September.
By August, the price of gold increases by $2 to $352 per ounce and Joe decides to sell the
contract in order to realize a profit. The 1,000 ounce contract would now be worth $352,000 and
the profit would be $2,000. Given the very high leverage (remember the initial margin was
$2,000), by going long, Joe made a 100% profit!

Of course, the opposite would be true if the price of gold per ounce had fallen by $2. The
speculator would have realized a 100% loss. It's also important to remember that throughout the
time that Joe held the contract, the margin may have dropped below the maintenance margin
level. He would, therefore, have had to respond to several margin calls, resulting in an even
bigger loss or smaller profit.

Going Short
A speculator who goes short - that is, enters into a futures contract by agreeing to sell and deliver
the underlying at a set price - is looking to make a profit from declining price levels. By selling
high now, the contract can be repurchased in the future at a lower price, thus generating a profit
for the speculator.

Let's say that Sara did some research and came to the conclusion that the price of oil was going
to decline over the next six months. She could sell a contract today, in November, at the current
higher price, and buy it back within the next six months after the price has declined. This strategy
is called going short and is used when speculators take advantage of a declining market.

Suppose that, with an initial margin deposit of $3,000, Sara sold one May crude oil contract (one
contract is equivalent to 1,000 barrels) at $25 per barrel, for a total value of $25,000.

By March, the price of oil had reached $20 per barrel and Sara felt it was time to cash in on her
profits. As such, she bought back the contract which was valued at $20,000. By going short, Sara
made a profit of $5,000! But again, if Sara's research had not been thorough, and she had made
a different decision, her strategy could have ended in a big loss.

Spreads
As you can see, going long and going short are positions that basically involve the buying or
selling of a contract now in order to take advantage of rising or declining prices in the future.
Another common strategy used by futures traders is called “spreads.”

Spreads involve taking advantage of the price difference between two different contracts of the
same commodity. Spreading is considered to be one of the most conservative forms of trading in
the futures market because it is much safer than the trading of long/short (naked) futures
contracts.

There are many different types of spreads, including:

Calendar Spread - This involves the simultaneous purchase and sale of two futures of
the same type, having the same price, but different delivery dates.

Intermarket Spread - Here the investor, with contracts of the same month, goes long in
one market and short in another market. For example, the investor may take Short June
Wheat and Long June Pork Bellies.

Inter-Exchange Spread - This is any type of spread in which each position is created in
different futures exchanges. For example, the investor may create a position in the
Chicago Board of Trade (CBOT) and the London International Financial Futures and
Options Exchange (LIFFE).