Shortselling Flashcards
What is the process of short selling?
Step 1: Jane borrows stocks of XYZ from a third party, Joe – a broker will arrange the borrowing of the securities from others who have them in margin accounts and lend them to the short seller.
Step 2: Jane’s broker sells the borrowed securities in the open market like any other sale. Assume the broker managed to sell XYZ for $10 per share.
Step 3: Assume XYZ declines to $5 per share at the end of the month. Jane would then instruct the broker to repurchase the stock at the currently lower price and cancel the SHORT POSITION (i.e. by replacing the borrowed stock from Joe).
Step 4: Jane profits equal the difference between the price at which the borrowed stock was sold and the price at which it was repurchased.
What are short sales?
The sale of a stock NOT OWNED by the investor but BORROWED from a third party in order to take advantage of an expected decline in the price of the stock.
What are some things to keep in mind?
A short seller must be approved for a margin account because he/she is liable for “borrowing” securities from another investor and is therefore subject to a margin call.
Remember: short selling is defined as the sale of securities that the seller does not own!
The investor is said to be in a short position since he/she must repay it in the future; hopefully it can be repurchased at a lower price so he/she can make a profit!
The investor must leave the proceeds of the short sale as well as a certain portion of the market value in addition to the proceeds with the dealer.
Basically, the investor must put up more funds to show that she/he is good for repurchasing the “borrowed” stocks in the future, even if their market price ends up increasing.
What are the details of short selling?
Short Sellers are responsible for paying dividends declared on borrowed stocks to the person who “lent” them to the short seller.
Dividends declared on any stock sold short must be covered by the short seller because the person from whom he/she borrowed it from technically still owns the stock and expects dividends paid on it.
Short sellers must have a margin account to sell short and must put up margin as if they had gone “long”. The margin can consist of cash or any restricted securities held long
There is no time limit on a short sale. The only protection arises when the lender wants the stock back but in most cases, brokers can borrow them from someone else.
Short sales are permitted only on rising prices or an uptick. A short seller can sell short at the last trade price only if that price exceeded the last different price before it (i.e. going up).
The net proceeds from a short sale, plus the required margin, are held by the broker; thus, no funds are immediately received by the short seller. The lender is fully protected, i.e. if the price of the stock rises, the short seller will have to put up more funds to satisfy the margin requirement or repurchase the borrowed stock for the lender.
What are the difficulties of short selling?
Problems borrowing sufficient number of shares
Responsibility of maintaining an adequate margin
Liability for any dividends paid
Threat of being required to buy shares at undesirable prices if the margin is not maintained and/or the borrowed stock is called by its owners and cannot be replaced
Difficulty in obtaining up-to-date info on total short sales
Possibility of volatile prices should a rush to cover the lender’s shares occur
Potential for unlimited loss
