Selling Short

[EightCounts]

Can someone please explain this excerpt from Cramer's book, Confessions of a Street Addict? I am not able to grasp the concept of selling short. So dumbing it down for me would be awesome.


But we were sloppy about our comeback. That was the summer a clerk on the trading desk made the $40,000-in-a-nanosecond error, my worst ever, because he didn't listen to a simple instruction I had given to cover a short in Philip Morris, forcing me to pay the dividend that normally the company owes. (The short seller is just borrowing the stock from someone else to sell it short, and the short seller has to pay that dividend to that someone else unless he covers his position first, that is, buys back the stock, which you should always do, and which I had explicitly said to do.)

[Albert0373]

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.

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.

Source: Investopedia.com

[EightCounts]

Thanks for the info, I'll be using that site frequently. But one question: How does the person/company that loans the stock benefit?

[AJLightning]

Love the KNOWLEDGE...:idea:

thanks AL

[AJLightning]

Thanks for the info, I'll be using that site frequently. But one question: How does the person/company that loans the stock benefit?



the loaner or broker will hold that "short stock" at that price...when it goes up, they will sell it higher to us, but at the low price it was shorted at??? :idea:

make sense...just a guess :confused:

[aiki14]

The broker will sell options positions against the short to hedge the position. Loan the short seller 100 shares and buy a put and sell a call. If the price drops the put covers the down side, if it goes up the borrower pays the broker the upside. The call premium covers the price of the put. Add in the various commissions and the broker makes money regardless.

[concrete]

Add in the various commissions and the broker makes money regardless.

Aiki:

When you put it that way, isn't calling him/her a broker, a misnomer; maybe bookie with be a more apt sobriquet?

[aiki14]

Aiki:

When you put it that way, isn't calling him/her a broker, a misnomer; maybe bookie with be a more apt sobriquet?

A rose by any other name still gets the vig. The retail side of the house makes money off trading clients money.

[aiki14]

Aiki:

When you put it that way, isn't calling him/her a broker, a misnomer; maybe bookie with be a more apt sobriquet?

A rose by any other name still gets the vig. The retail side of the house makes money off trading clients money.

[Mustard182]

As an account holder, is there anyway that you can make sure your shares are not shorted? This would matter more for stocks with a very high short ratio.

[aiki14]

As an account holder, is there anyway that you can make sure your shares are not shorted? This would matter more for stocks with a very high short ratio.

Actually there is, you can ask for the certificates. There have been attempts by shareholders to request certificates en masse when naked shorting was suspected.

[Albert0373]

The broker will sell options positions against the short to hedge the position. Loan the short seller 100 shares and buy a put and sell a call. If the price drops the put covers the down side, if it goes up the borrower pays the broker the upside. The call premium covers the price of the put. Add in the various commissions and the broker makes money regardless.

Thanks Jim; I never knew that.

[Svenwulf]

investopedia is great, here is some more help:

http://en.wikipedia.org/wiki/Short_selling

although aiki's explanation as to the benefit to the stock loaner is no doubt profitable, it would fall under "proprietary trading," by the broker, and should be considered separately from the loan transaction. notice:

Fees
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 you (rise in price), money will be removed from your cash account and moved to your margin account. If short shares continue to rise in price, and you don't have enough funds in your cash account to cover the position, you'll begin to borrow on margin for this purpose. At that time, you'll also begin to accrue margin interest charges. These will be computed and charged the same as for a regular margin debit. When short selling a stock that pays dividends and the ex-dividend date passes while you are short the stock, the dividend will be deducted from your account. It should also be noted that contrary to standard finance theory, the short seller often does not enjoy the benefits of the proceeds of the short sale to earn interest or reduce outstanding margin amounts. The brokers generally do not pass this benefit on to the retail client, unless the client is very large. What this means is that if you short sell $1000 of stock A and buy $1000 of stock B with the proceeds, you will lose the interest earned on a surplus $1000 sitting in cash, or alternatively, you'll have to pay interest on the $1000, if you don't have any surplus cash.



loaning stock is a profitable business. it can also be an additional source of income generated by a firm's portfolio. also pretty easy to collect a finder's fee on your current holdings, right? hard to borrow shares (stocks with a high short interest, for example) command a greater premium (and finder's fee) when loaned.

but in the end, us retail investor will always get the short end: as aiki correctly stated, unless we request physical delivery of our certificates, our shares are freely borrowed. the possibility of the borrower being required to buy-in if we decide to sell our shares still exists, but the obscurity of back office transactions make this confirmation improbable. on the other side, notice that most of us would never qualify for the "shorter's rebate," or earned interest on the cash generated by our short sales. also, we require our broker to locate shares to borrow for sale short, and not all broker's offer the same level of service in this area. rest assured, the broker already wins on the short sale transaction, any proprietary gains are strictly frosting on the cake. other then physical delivery of certificates, few options are available to protect your shares against loan. one of the more creative ive discussed is the dividend capture plan. but one should not attribute all share price declines to short sellers. short sellers offer a valuable service to the market, and take a lot of risk to do it. of course, naked shorting takes no risk, is generally a crime, and imo is never excusable.

an interesting read on derivatives (options)-
http://en.wikipedia.org/wiki/Derivative_%28finance%29

fun with the history of futures contracts?!?
http://www.fenews.com/fen41/teach_notes/teaching-notes.html

[Rich]

I asked for certificates once and they said that wasnt done any more.
Of course, that was Dublin Securities in Dublin Ohio, which is now defunt and
their top notch layers got them off after ripping me and and 1000's of other investors.

I guess the naked shorts is bad because:

1. Uses our money without compensation.
2. Can cause a breakdown of securities by the potential of loaning more than they can cover, thus, putting our securities at great risk.
3. NOT Ethical

Anything else ??

http://www.sec.gov/litigation/admin/3439130.txt

[wallstreetsedge]

well all shorts would be considered naked.. there are some benefits for short selling. first cash requirements are only 50% and you can always get a rebate. there are a few things you should think about when you short sell... first make sure the stock is liquid (or you're just very sure), make sure there are no short restrictions, and check out the time to cover. some stocks especially stocks on short restriction have shorter time periods to cover.

one way to get around paying a dividend if your short... is if you have a significant short position call your broker and ask for a rebate. when you buy on margin, you have to pay interest. if you short a stock, interest is earned and normally you dont get it but if you ask your broker, they can do it for you... but again only if its a significant position

as for certificates, most dont do it any more... also its not really the broker who gets it for you. its up to the transfer agent/clearing firm

one way to prevent your stock from being sold short is when you put in an order, make note to have it "not held" or "not held in street name"

as for shorting.. the risk is basically unlimited. on the downside of being long, you can lose your entire investment (or double+ if your margined or using day trading buying power) but when your short its unlimited because a stock can go up 100000% theoretically

not sure what you mean by short selling as being unethical...

[Rich]

Ken, by unethical I meant that if a broker is selling/lending my shares and making money on my personal property without sharing the booty profits with me, then I believe that is extortion, and therefore not ethical. I believe its illegal from what Aiki and other articles which I have previously read.

If there is a place on scottrade to enter in the 'not held' I will do it. I'm trying to make money, and shorts as I understand them drive down the price of my stocks that I purchased. This is another reason that using my shares is unethical, I bought the stocks to have them increase in value, by the broker allowing my shares to be shorted without my permission is clearly an act of extortion if shorts drives down the stock prices.

I could be wrong in my assumptions, I dont' think I am....

Rich

[aiki14]

well all shorts would be considered naked..

Are you sure you understand what "naked shorting" is?
Because I am here to help you Kenny, and anyone else who is curious about what Naked Shorting is, here is an article from Investors Business Daily (note, the article is from last sept, I think):

Naked Shorting -- Why not just ignore the law?
by Margaret Jones, Wall-Street.com
Lately there's been a lot of discussion about naked shorting. Some people go as far as to call it "Stockgate". Others say it is no big deal. To understand the situation, first you have to understand the definitions of shorting and naked shorting.
The short seller sells stock that he does not own. He has borrowed it and will sooner or later need to return it. He assumes that the stock will fall in value and he'll be able to buy it back at a lower price when necessary to return it; thereby making a tidy profit. There have been market systems which did not allow shorting, citing various problems and abuses. However it is perfectly legal in our present system and many feel that shorting contributes to increased market stability.
Naked shorting, however, is not legal in our country at present. In this case, per the SEC's definition, "...the seller does not borrow or arrange to borrow the securities in time to make delivery to the buyer within the standard three-day settlement period. As a result, the seller fails to deliver securities to the buyer when delivery is due; this is known as a 'failure to deliver' or 'fail.'"
Now, there are some situations where a stock will, technically, be naked short temporarily while market makers juggle ownership and while paper certificates catch up to electronic-trading reality. This is practical and legal and is not a problem unless it is abused. However, when the stock is simply created electronically and time passes (sometimes ad infinitum) without the stock certificate being delivered, this is akin to counterfeiting!
Those journalists who say that naked shorting is not a problem point out that many of the vociferous critics are those whose companies are in trouble or whose stock has been overvalued by too-enthusiastic investors. Well, really -- what sort of company do you think will be impacted? Berkshire-Hathaway? Yes, a few CEOs use naked shorting as an excuse for poor stock performance but this does not mean that badly run companies and their shareholders are excluded from protection of the law. And who said that SEC regulations do not apply when trading a shaky stock?
So, two groups of people are complaining about naked shorting.
First, the companies whose stock is being naked shorted are upset. Of course they are not happy about the regular shorting that occurs but the naked shorting dilutes the stock further, drives the price down faster, and adds insult to injury.
Secondly, ordinary investors who play the game legally are rankled by the unfair advantage of those who can simply create stock out of thin air and sell it. Golly, I'd like to print some stock certificates on my inkjet and sell them but I'd land in jail faster than you can say "Martha Stewart"!
Everybody agrees that naked shorting exists. There have been blatant cases where the number of shares traded greatly exceeded the number of shares issued. However, the extent of the problem has been hard to measure. On January 3 of this year the SEC put into effect Regulation SHO, which sheds some light on the problem by mandating the publishing of a weekly "threshold list" of those stocks with a real "failure to deliver" problem. Well, the lists confirm that there are a lot of shorted stocks and they remain shorted week after week. But the lists do not reveal who is doing the shorting. And unfortunately Reg. SHO has no real teeth with which to effect a solution.
A number of media articles, columns and blogs have speculated on who is behind the naked shorting and various ways it may be accomplished. The writers often mention frustration in obtaining concrete data from the brokers, the exchanges and the DTCC. When researchers are stonewalled I get a whif of rotting fish from behind those walls.
Avoiding paranoid conspiracy theories and Chicken Little scenarios, there is still cause for concern. The rules are simply being ignored. Moreover, when there are loopholes through which illegal money can be extracted, an increasing number of leeches will gather with vacuum hoses. Do you remember the banking fiasco of the '80's? Bankers convinced the government that they were honest, responsible people and did not need so many rules. They forgot their group was upstanding because no criminal would bother with such a well-regulated industry. Once the rules were relaxed the sharks moved in and the honest bankers were no match for them.
And to make matters worse, the SEC is planning to do away with paper certificates completely. Although this is practical for the long run, we all know what happens when you go digital with a system which is already faulty on paper!
Whether or not naked shorting is at Stockgate crisis proportions right now, if we let the situation slide we will have deja vue all over again.
For links on this subject and more information than we can present, here, go to http://www.wall-street.com/nakedshorting.html.
This article is sponsored by the Exceptional Growth Companies at http://www.wall-street.com and by the Microcap Leaders at http://www.microcapleaders.com.
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[Rich]

Once the rules were relaxed the sharks moved in and the honest bankers were no match for them.


Wow, thats a life long lesson to be learned in every phase of life, and the earlier one learns it the less grief one will have in life on every level.

Rich

[wallstreetsedge]

aiki i know what naked short selling it but let me ask you this.. when youre shorting a stock, do you actually call up and ask if you have any to borrow or do you just throw the order in? besides... most trading desks will tell you to just put the order in and let the clearing firm deal with it. as long as a stock is marginable, the chances are pretty good that there are shares to short

by the way rich, its not in a margin account is it?

[Rich]

Ken, I asked for certicates of the stock when I bought it. I have yet to have shorted a stock, I have enough problems finding exit points :-)

Rich

[netwrangler]

well all shorts would be considered naked.


aiki i know what naked short selling it but let me ask you this.. when youre shorting a stock, do you actually call up and ask if you have any to borrow or do you just throw the order in? besides... most trading desks will tell you to just put the order in and let the clearing firm deal with it. as long as a stock is marginable, the chances are pretty good that there are shares to short

by the way rich, its not in a margin account is it?Nice try but no cigar!

Of course there is a difference between shorting and naked shorting.

Are you suggesting that all brokers will give you naked shorts? Got any data to support that?

WSE, you got caught in a statement that was simply horse-puckey.
Your posts are usually vague enough to allow you to wriggle out of confronting such inconvenient truths.
Doesn't look like that works this time.

[aiki14]

aiki i know what naked short selling it but let me ask you this.. when youre shorting a stock, do you actually call up and ask if you have any to borrow or do you just throw the order in? besides... most trading desks will tell you to just put the order in and let the clearing firm deal with it. as long as a stock is marginable, the chances are pretty good that there are shares to short

by the way rich, its not in a margin account is it?

I don't know about the Bucket shop you work in Kenny, but when I place an order with Merrill or even the lowly E*trade, I am sure as reputable brokers they borrow the shares. Occasionally they tell me no shares were available to borrow, as in wednesday when I was attempting to short ABK.
Your statement that "most trading desks" will tell you to place the order and let the clearing firm"deal with it" implies a criminal action by "most trading desks". Most desks will reject the ticket and not place the trade. Not to mention the fact that most retail traders are not talking to the trading desk anyway.
You talk a fair game Kenny, but there's always some little thing that doesn't square, you must be great with the rubes who fall for your pitch, but you're gonna have to polish your act to reach the big time.

[Rich]

Im a little confused, who allows the stocks to be shorted, naked or otherwise?

AJ's third post at this link suggests that its the companies themselves are the ones doing it. His pasted post lists stocks of companies who are not allowed to short due to naked shorts being discovered. So, was it the brokers or the companies themselves. Thought this one sentance below goes with this discussion.

http://www.onlinetradersforum.com/showthread.php?t=12266



WWW.BUYINS.NET is a service designed to help bonafide shareholders of publicly traded US companies fight naked short selling. Naked short selling is the illegal act of short selling a stock when no affirmative determination has been made to locate shares of the stock to hypothecate in connection with the short sale. Buyins.net has built a proprietary database that uses Threshold list feeds from NASDAQ, AMEX and NYSE to generate detailed and useful information to combat the naked short selling problem.

[aiki14]

Im a little confused, who allows the stocks to be shorted, naked or otherwise?

AJ's third post at this link suggests that its the companies themselves are the ones doing it. His pasted post lists stocks of companies who are not allowed to short due to naked shorts being discovered. So, was it the brokers or the companies themselves. Thought this one sentance below goes with this discussion.

http://www.onlinetradersforum.com/showthread.php?t=12266

Rich, and anyone else who's interested,
This is the definitive explanation of Rule SHO, the short sale rule from the SEC website:
http://www.sec.gov/spotlight/keyregshoissues.htm
It is too long to post here, but it has the answers you were looking for.

[wallstreetsedge]

rich out of curiousity why did you want certificates?

aiki, you couldnt borrow any abk to short because theres such a huge short restriction on it. i had an order in yesterday to short 2000 shares limit 14.99 and only got filled on 100 shares going through fidelity. when i tried to put it in through tradestation and tradeking, they were rejected.

other reasons why you might not be able to short a stock is because the % being margined is too small, margin requirements are too high, or balance sheet is too weak.

as for talking to trading, anyone inside can talk to them about basically anything - usually regarding restricted stock, seeing hidden bids and asks on pinks and bb's, what the order book looks like, buying/selling in an average cost account, borrowing stock, who's on the bid, who's on the ask, mark ups, mark downs, and working a position (making a market) using an individual or institutions position



if you wanted to talk to the trading desk for one of your brokerage accts, its more limited.. you can only talk to them about seeing hidden bids/asks on pinks or bb's, asking about borrowing stock, and working a position for you - most of the time they wont tell you whos on the bid/ask and how many shares if its not held

[Rich]

I only had some mutual funds prior to Dublin Securities ripping me off, and when I bought some stocks from them I remember that my father always recieved certificates. In the old days when you bought a stock the seller had to send them into the broker and he in turn sent them to the new owner, could take some time. Well, after 10 days I asked where my certificates were and thats when I was told they didn't do that any longer. I wish I did get them, I could have least wall papered my walls with the trash they gave me. CCCD, Enviromental Safety First is one I remember that went defunt right after they sold to me.

Rich