In finance, short selling also known as shorting or going short is the practice of selling securities or other financial instruments that are not currently owned usually borrowed , and subsequently repurchasing them "covering". In the event of an interim price decline, the short seller profits, since the cost of re purchase is less than the proceeds received upon the initial short sale.
Conversely, the short position closes out at a loss if the price of a shorted instrument rises prior to repurchase. Potential loss on a short sale is theoretically unlimited, as there is no theoretical limit to a rise in the price of the instrument. However, in practice, the short seller is required to post margin or collateral to cover losses, and inability to do so in a timely way would cause its broker or counterparty to liquidate the position.
In the securities markets, the seller generally must borrow the securities to effect delivery in the short sale. In some cases, the short seller must pay a fee to borrow the securities and must additionally reimburse the lender for cash returns the lender would have received had the securities not been loaned out.
Short selling is most commonly done with instruments traded in public securities, futures or currency markets , due to the liquidity and real-time price dissemination characteristic of such markets and because the instruments defined within each class are fungible. In practical terms, "going short" can be considered the opposite of the conventional practice of " going long ", whereby an investor profits from an increase in the price of the asset. Mathematically, the return from a short position is equivalent to that of owning being "long" a negative amount of the instrument.
Nevertheless, one main discrepancy in the short against a long position is that the short position must exclude the dividends paid, if any. A short sale may have a variety of objectives. Speculators may sell short hoping to realize a profit on an instrument that appears overvalued, just as long investors or speculators hope to profit from a rise in the price of an instrument that appears undervalued. Traders or fund managers may hedge a long position or a portfolio through one or more short positions.
In contrast to a traditional merchant who starts out to "buy low, sell high", a short-seller starts out to "sell high, buy low", or even to "buy high, sell low" when this buy is in fact "on tick".
Research indicates that banning short selling is ineffective and has negative effects on markets. The following example describes the short sale of a security. To profit from a decrease in the price of a security, a short seller can borrow the security and sell it expecting that it will be cheaper to repurchase in the future.
When the seller decides that the time is right or when the lender recalls the securities , the seller buys equivalent securities and returns them to the lender. The process relies on the fact that the securities or the other assets being sold short are fungible ; the term "borrowing" is therefore used in the sense of borrowing cash, where different bank notes or coins can be returned to the lender as opposed to borrowing a car, where the same car must be returned.
A short seller typically borrows through a broker , who is usually holding the securities for another investor who owns the securities; the broker himself seldom purchases the securities to lend to the short seller. In most market conditions there is a ready supply of securities to be borrowed, held by pension funds, mutual funds and other investors. The act of buying back the securities that were sold short is called "covering the short" or "covering the position".
A short position can be covered at any time before the securities are due to be returned. Once the position is covered, the short seller is not affected by subsequent rises or falls in the price of the securities, as he already holds the securities required to repay the lender.
Short selling refers broadly to any transaction used by an investor to profit from the decline in price of a borrowed asset or financial instrument.
However some short positions, for example those undertaken by means of derivatives contracts , are not technically short sales because no underlying asset is actually delivered upon the initiation of the position. Derivatives contracts include futures , options , and swaps. This, combined with the seemingly complex and hard-to-follow tactics of the practice, has made short selling a historical target for criticism.
The London banking house of Neal, James, Fordyce and Down collapsed in June , precipitating a major crisis that included the collapse of almost every private bank in Scotland, and a liquidity crisis in the two major banking centres of the world, London and Amsterdam.
The bank had been speculating by shorting East India Company stock on a massive scale, and apparently using customer deposits to cover losses. It was perceived [ citation needed ] as having a magnifying effect in the violent downturn in the Dutch tulip market in the eighteenth century. The term "short" was in use from at least the mid-nineteenth century. It is commonly understood that "short" is used because the short-seller is in a deficit position with his brokerage house.
Short sellers were blamed for the Wall Street Crash of Edgar Hoover said he would investigate short sellers for their role in prolonging the Depression. Negative news, such as litigation against a company, may also entice professional traders to sell the stock short in hope of the stock price going down.
During the dot-com bubble , shorting a start-up company could backfire since it could be taken over at a price higher than the price at which speculators shorted. During the financial crisis , critics argued that investors taking large short positions in struggling financial firms like Lehman Brothers , HBOS and Morgan Stanley created instability in the stock market and placed additional downward pressure on prices.
In response, a number of countries introduced restrictive regulations on short-selling in and Naked short selling is the practice of short-selling a tradable asset without first borrowing the security or ensuring that the security can be borrowed — it was this practice that was commonly restricted. That ban expired several weeks later as regulators determined the ban was not stabilizing the price of stocks.
Temporary short-selling bans were also introduced in the United Kingdom, Germany, France, Italy and other European countries in to minimal effect. Investors continue to argue this only contributes to market inefficiency.
Short selling stock works similar to buying on margin , therefore also requires a margin account as well:. To sell stocks short in the U. This is referred to as a locate. Brokers have a variety of means to borrow stocks to facilitate locates and make good on delivery of the shorted security. The vast majority of stocks borrowed by U. Institutions often lend out their shares to earn extra money on their investments.
These institutional loans are usually arranged by the custodian who holds the securities for the institution. The cash collateral is then invested by the lender, who often rebates part of the interest to the borrower.
The interest that is kept by the lender is the compensation to the lender for the stock loan. Brokerage firms can also borrow stocks from the accounts of their own customers. Typical margin account agreements give brokerage firms the right to borrow customer shares without notifying the customer. In general, brokerage accounts are only allowed to lend shares from accounts for which customers have debit balances , meaning they have borrowed from the account. SEC Rule 15c imposes such severe restrictions on the lending of shares from cash accounts or excess margin fully paid for shares from margin accounts that most brokerage firms do not bother except in rare circumstances.
These restrictions include that the broker must have the express permission of the customer and provide collateral or a letter of credit. Most brokers allow retail customers to borrow shares to short a stock only if one of their own customers has purchased the stock on margin.
Brokers go through the "locate" process outside their own firm to obtain borrowed shares from other brokers only for their large institutional customers. Stock exchanges such as the NYSE or the NASDAQ typically report the "short interest" of a stock, which gives the number of shares that have been legally sold short as a percent of the total float.
Alternatively, these can also be expressed as the short interest ratio , which is the number of shares legally sold short as a multiple of the average daily volume. These can be useful tools to spot trends in stock price movements but for them to be reliable, investors must also ascertain the number of shares brought into existence by naked shorters.
Speculators are cautioned to remember that for every share that has been shorted owned by a new owner , a 'shadow owner' exists i. When a security is sold, the seller is contractually obliged to deliver it to the buyer. If a seller sells a security short without owning it first, the seller must borrow the security from a third party to fulfill its obligation.
Otherwise, the seller fails to deliver, the transaction does not settle , and the seller may be subject to a claim from its counterparty. Certain large holders of securities, such as a custodian or investment management firm, often lend out these securities to gain extra income, a process known as securities lending. The lender receives a fee for this service.
Similarly, retail investors can sometimes make an extra fee when their broker wants to borrow their securities. This is only possible when the investor has full title of the security, so it cannot be used as collateral for margin buying.
Time delayed short interest data for legally shorted shares is available in a number of countries, including the US, the UK, Hong Kong, and Spain. The number of stocks being shorted on a global basis has increased in recent years for various structural reasons e.
The data is typically delayed; for example, the NASDAQ requires its broker-dealer member firms to report data on the 15th of each month, and then publishes a compilation eight days later. Some market data providers like Data Explorers and SunGard Financial Systems  believe that stock lending data provides a good proxy for short interest levels excluding any naked short interest. SunGard provides daily data on short interest by tracking the proxy variables based on borrowing and lending data it collects.
Days to Cover DTC is a numerical term that describes the relationship between the number of shares in a given equity that has been legally short-sold and the number of days of typical trading that it would require to 'cover' all legal short positions outstanding.
For example, if there are ten million shares of XYZ Inc. Short Interest is a numerical term that relates the number of shares in a given equity that have been legally shorted divided by the total shares outstanding for the company, usually expressed as a percent. If however, shares are being created through naked short selling, "fails" data must be accessed to assess accurately the true level of short interest.
Borrow cost is the fee paid to a securities lender for borrowing the stock or other security. However, certain stocks become "hard to borrow" as stockholders willing to lend their stock become more difficult to locate. A naked short sale occurs when a security is sold short without borrowing the security within a set time for example, three days in the US.
This means that the buyer of such a short is buying the short-seller's promise to deliver a share, rather than buying the share itself. The short-seller's promise is known as a hypothecated share. When the holder of the underlying stock receives a dividend, the holder of the hypothecated share would receive an equal dividend from the short seller.
Naked shorting has been made illegal except where allowed under limited circumstances by market makers. In the US, arranging to borrow a security before a short sale is called a locate. In , to prevent widespread failure to deliver securities, the U. Requirements that are more stringent were put in place in September , ostensibly to prevent the practice from exacerbating market declines.
The rules were made permanent in When a broker facilitates the delivery of a client's short sale, the client is charged a fee for this service, usually a standard commission similar to that of purchasing a similar security. If the short position begins to move against the holder of the short position i. If short shares continue to rise in price, and the holder does not have sufficient funds in the cash account to cover the position, the holder begins to borrow on margin for this purpose, thereby accruing margin interest charges.
These are computed and charged just as for any other margin debit. Therefore, only margin accounts can be used to open a short position. When a security's ex-dividend date passes, the dividend is deducted from the shortholder's account and paid to the person from whom the stock is borrowed. For some brokers, the short seller may not earn interest on the proceeds of the short sale or use it to reduce outstanding margin debt.
These brokers may not pass this benefit on to the retail client unless the client is very large.More...