Monday, September 22, 2008

short selling

In finance, short selling or "shorting" is the practice of selling a financial instrument the seller does not own, in the hope of repurchasing them later at a lower price. This is done in an attempt to profit from an expected decline in price of a security, such as a stock or a bond, in contrast to the ordinary investment practice, where an investor "goes long," purchasing a security in the hope the price will rise. Often the seller will "borrow" or "rent" the items to be sold, and later repurchase identical items for return to the lender. However, the practice is risky in that prices may rise indefinitely, even beyond the net worth of the short seller.

The act of repurchasing is known as "covering" a position. The term "short selling" or "being short" is often also used as a blanket term for strategies that allow an investor to gain from the decline in price of a security. Those strategies include buying options known as puts. A put option consists of the right to sell an asset at a given price; thus the owner of the option benefits when the market price of the asset falls. Similarly, a short position in a futures contract, or to be short on a futures contract, means the holder of the position has an obligation to sell the underlying asset at a later date, to close out the position.

To profit from a stock price going down, short sellers can borrow a 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 shares), the seller buys back the shares in order to return them to the lender. The process generally relies on the fact that securities are fungible, so that the shares returned do not need to be the same shares as were originally borrowed.

The short seller borrows from their broker, who usually in turn has borrowed the shares from some other investor who is holding his shares long; the broker itself seldom actually purchases the shares to lend to the short seller.[1] The lender of the shares does not lose the right to sell the shares. Short selling is the opposite of "going long." The short seller takes a fundamentally negative, or "bearish" stance, intending to "sell high and buy low," to reverse the conventional adage. The act of buying back the shares which were sold short is called 'covering the short'. Day traders and hedge funds often use short selling to allow them to profit on trading in stocks which they believe are overvalued, just as traditional long investors attempt to profit on stocks which are undervalued by buying those stocks.

In the U.S., in order to sell stocks short, the seller must arrange for a broker-dealer to confirm that it is able to make delivery of the shorted securities. This is referred to as a "locate." Brokers have a variety of means to borrow stocks in order to facilitate locates and make good delivery of the shorted security. The vast majority of stock borrowed by U.S. brokers come from loans made by the leading custody banks and fund management companies (see list below).

Sometimes brokers are able to borrow stocks from their customers who own "long" positions. In these cases, if the customer has fully paid for the long position, the broker cannot borrow the security without the express permission of the customer, and the broker must provide the customer with collateral and pay a fee to the customer. In cases where the customer has not fully paid for the long position (meaning the customer borrowed money from the broker in order to finance the purchase of the security), the broker will not need to inform the customer that the long position is being used to effect delivery of another client's short sale.

Most brokers will allow retail customers to borrow shares to short a stock only if one of their own customers has purchased the stock on margin. Brokers will 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 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 sold short as a multiple of the average daily volume. These can be useful tools to spot trends in stock price movements

For example, assume that shares in XYZ Company currently sell for $10 per share. A short seller would borrow 100 shares of XYZ Company, and then immediately sell those shares for a total of $1000. If the price of XYZ shares later falls to $8 per share, the short seller would then buy 100 shares back for $800, return the shares to their original owner (paying a fee for having borrowed the shares) and make a $200 profit (minus the fee for having borrowed the shares).

This practice has the potential for losses as well. For example, if the shares of XYZ that one borrowed and sold in fact went up to $25, the short seller would have to buy back all the shares at $2500, losing $1500. Because a short is the opposite of a long (normal) transaction, everything is the mirror opposite compared to the typical trade: the profit is limited but the loss is unlimited. Since the stock cannot be repurchased at a price lower than zero, the maximum gain is the difference between the current stock price and zero. However, because there is no ceiling on how much the stock price can go up (thereby costing short transactions money in order to buy the stocks back), an investor can theoretically lose an arbitrarily large amount of money if a stock continues to rise. Also, in actual practice, as the price of XYZ Company began to rise, the short seller would eventually receive a margin call from the brokerage, demanding that the short seller either cover his short position or provide additional cash in order to meet the margin requirement for XYZ Company stock.

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