Generally, the two main reasons to short are to either speculate or to hedge.
When you speculate, you are watching for fluctuations in the market in order to quickly make a big profit off of a high-risk investment. Speculation has been perceived negatively because it has been likened to gambling. However, speculation involves a calculated assessment of the markets and taking risks where the odds appear to be in your favor. Speculating differs from hedging because speculators deliberately assume risk, whereas hedgers seek to mitigate or reduce it. (For more insight, see What is the difference between hedging and speculation?)
Speculators can assume a high loss if they use the wrong strategies at the wrong time, but they can also see high rewards. 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. (For more on this trade, see The Greatest Currency Trades Ever Made.)
Speculators can benefit the market because they increase trading volume, assume risk and add market liquidity. However, high amounts of speculative purchases can contribute to an economic bubble and/or a stock market crash.
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.
Short selling is highly regulated by securities authorities around the world, not only because of its risky nature, but also because it is prone to manipulation by dishonest short sellers who may use unethical tactics to drive down stock prices. Such “short and distort” schemes and other abuses such as bear raids are more prevalent during severe bear markets. Not surprisingly, the two biggest recent changes in US short selling regulations – Regulation SHO and Rule 201 – were implemented in the years after the “tech wreck” of 2000-02 and the global bear market of 2008-09.
In January 2005, the SEC implemented Regulation SHO, which updated short sale regulations that had been essentially unchanged since 1938. Regulation SHO specifically sought to curb the practice of “naked” short selling, which had been rampant in the 2000-02 bear market.
In a naked short sale, the seller does not borrow or arrange to borrow the shorted security in time to make delivery to the buyer within the standard three-day settlement period. (Remember that just as there is a seller on the other side of every buy transaction, there is a buyer on the other side of every short sale trade). This results in the seller failing to deliver the security to the buyer upon settlement, and is known as a “failure to deliver” or “fail” in short selling parlance. Such naked shorting can result in relentless selling pressure on targeted stocks, and cause huge declines in their prices.
In order to address issues associated with failures to deliver and curb naked short selling, Regulation SHO imposed “locate” and “close-out” requirements on broker-dealers for short sales. (The “locate” requirement is discussed in the “Executing a Short Sale” section of this tutorial.)
The “close-out” requirement is applicable to securities in which there are a relatively substantial number of extended failures to deliver (known as “threshold securities”). Regulation SHO requires broker-dealers to close out positions in threshold securities where failure-to-deliver conditions have persisted for 13 consecutive settlement days. Such closing out requires the broker-dealer to buy back the shorted securities in the market, which may drive up their prices and inflict significant losses on short sellers.
Short selling was synonymous with the “uptick rule” for almost 70 years in the US. The rule was implemented by the SEC in 1938 and required every short sale transaction to be entered into at a price that was higher than the previous traded price, i.e., on an uptick. It was designed to prevent short sellers from aggravating the downward momentum in a stock when was already declining. The SEC repealed the uptick rule in July 2007. A number of market experts believe this repeal contributed to the ferocious bear market and unprecedented market volatility of 2008-09.
In February 2010, the SEC adopted an “alternative uptick rule” – also known as “Rule 201” – that restricts short selling by triggering a circuit breaker when a stock has dropped at least 10% in one day. The SEC said this would enable sellers of long positions to stand “in the front of the line” and sell their shares before any short sellers once the circuit breaker is triggered. With US and global equities recovering from a severe bear market at the time, the SEC also said that the rule was intended to promote market stability and preserve investor confidence.
Short Selling and Margin
Short selling can generally only be undertaken in margin accounts, which are accounts offered by brokerages that allow investors to borrow money to trade securities. Because of the higher degree of risk involved in short selling, the short seller has to ensure that he or she has always has adequate capital (or “margin”) in the account to hold on to the short position.
Short selling is the mirror image of buying stocks on margin. Thus, since the short seller is putting up less than the full value of the securities sold short, margin interest is charged by the broker-dealer on the balance amount of the transaction.
Note that although the short seller receives an inflow of funds from the shares sold short, these funds technically do not belong to the short seller, as they are obtained from the sale of a borrowed asset. The short seller therefore has to deposit an additional amount in the margin account as collateral for the short sale.
As with stocks purchased on margin, the margin requirement on short sales depends on the price and quality of the stock, since these determine the risk associated with the short position. Hence, blue-chip stocks with prices in the mid to high single digits have substantially lower margin requirements than speculative small-cap stocks that trade in the low single digits.
For instance, the margin requirement on a short sale may mandate that 150% of the value of the short sale be held in a margin account when the short sale is made. Since 100% comes from the short sale, the trader has to put up the balance 50% as margin.
Thus if a trader shorts 100 shares of a stock trading at $50, this margin requirement would require the trader to deposit an additional $2,500 (50% of $5,000) as margin. This margin is constantly monitored by the broker-dealer to ensure that it stays above the minimum mandated level (known as the "maintenance margin") and would need to be topped up without delay (the dreaded “margin call”) by the trader if the short sale does not work out—if the stock, instead of declining, appreciates significantly.
The following four points should be noted with regard to short sales in margin accounts:
- The short seller does not receive interest on the proceeds of a short sale.
- Margin maintenance requirements – ensuring that there is adequate margin to hold on to the short position – are based on the current market price of the security, and not on the initial price at which the security was sold short.
- Margin requirements can be fulfilled through contributing cash or eligible securities to the account.
- If the short seller is unable to meet the margin requirements, the broker-dealer will usually close out the short position at the prevailing market price, potentially saddling the short seller with a huge loss.
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