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What is a 'Short Sale'

A short sale is a transaction in which an investor sells borrowed securities in anticipation of a price decline and is required to return an equal number of shares at some point in the future. A short seller makes money if the stock goes down in price, while a long position makes money when the stock goes up. In real estate, a short sale means selling a house for less than the mortgage owed with the lender's approval.

BREAKING DOWN 'Short Sale'

A short sale is a transaction in which the seller does not actually own the stock that is being sold, but borrows it from the broker-dealer through which he or she is placing the sell order. The seller then has the obligation to buy back the stock at some point in the future. Short sales are margin transactions, and their equity reserve requirements are more stringent than for purchases.

Brokers borrow the shares for short sale transactions from custody banks and fund management companies that lend them as a revenue stream. Institutions that lend shares for short selling include JPMorgan Chase & Co. and Merrill Lynch Wealth Management.

The main advantage of a short sale is that it allows traders to profit from a drop in price. Short sellers aim to sell shares while the price is high, and then buy them later after the price has dropped -- the reverse of investors' aim to buy low and sell high.

Short sales are typically executed by investors who think the price of the stock being sold will decrease in the short term (such as a few months). Suppose an investor borrows 1,000 shares at $25 each, or $25,000. Let's say the shares fall to $20 and the investor closes the position. To close the position, the investor needs to purchase 1,000 shares at $20 each, or $20,000. The investor captures the difference between the amount he receives from the short sale and the amount he paid to close the position, or $5,000.

It is important to understand that short sales are considered risky because if the stock price rises instead of declines, then there is theoretically no limit to the investor's possible loss. As a result, most experienced short sellers will use a stop-loss order, so that if the stock price begins to rise, the short sale will be automatically covered with only a small loss.

Short sellers can buy the borrowed shares and return them to the broker any time before they're due. Returning the shares shields the short seller from any further price increases or decreases the stock may experience.

Short Sale Margin Requirements

Short sales allow for leveraged profits because these trades are always placed on margin, which means that the full amount of the trade does not have to be paid for. Therefore, the entire gain realized from a short sale can be much larger than the available equity in an investor's account would otherwise permit.

The margin rule requirements for short sales dictate that 150% of the value of the shares shorted needs to be initially held in the account. Therefore, if the value of the shares shorted is $25,000, the initial margin requirement would be $37,500. This prevents the proceeds from the sale from being used to purchase other shares before the borrowed shares are returned. However, since this includes the $25,000 from the short sale, the investor is only putting up 50%, or $12,500.

Short Sale Risks

Short selling has many risks that make it unsuitable for a novice investor. For starters, it limits maximum gains while potentially exposing the investor to unlimited losses. A stock can only fall to zero, resulting in a 100% loss for a long investor, but there is no limit to how high a stock can theoretically go. A short seller who has not covered his or her position with a stop-loss buyback order can suffer tremendous losses if the stock price runs higher.

For example, consider a company that becomes embroiled in scandal when its stock is trading at $70 per share. An investor sees an opportunity to make a quick profit and sells the stock short at $65. But then the company is able to quickly exonerate itself from the accusations by coming up with tangible proof to the contrary. The stock price quickly rises to $80 a share, leaving the investor with a loss of $15 per share for the moment. If the stock continues to rise, so do the investor's losses.  

Short selling also involves significant expenses. There are the costs of borrowing the security to sell, the interest payable on the margin account that holds it, and trading commissions.

Another major obstacle that short sellers must overcome is the fact that markets have historically moved in an upward trend over time, which works against profiting from broad market declines in any long-term sense. Furthermore, the overall efficiency of the markets often (but not always) builds the effect of any kind of bad news about a company into its current price. For instance, if a company is going to have a bad earnings report, in most cases, the price will have already dropped by the time earnings are announced. Therefore, in order to make a profit, most short sellers must be able to anticipate a drop in a stock's price before the market has had a chance to factor whatever causes the drop into the price.

Short sellers also need to consider the risk of short squeezes and buy-ins. A short squeeze occurs when a heavily shorted stock moves sharply higher, which "squeezes" more short sellers out of their positions and drives the price of the stock higher. Buy-ins occur when a broker closes short positions in a difficult-to-borrow stock whose lenders want it back.

Finally, regulatory risks arise with bans on short sales in a specific sector or in the broad market to avoid panic and selling pressures.

Near-perfect timing is required to make short selling work, unlike the buy-and-hold method that allows time for an investment to work itself out. Only disciplined traders should sell short, as it requires discipline to cut a losing short position rather than adding to it and hoping it will work out.

Many successful short sellers profit by finding companies that are fundamentally misunderstood by the market (i.e., Enron and Worldcom). For example, a company that is not disclosing its current financial condition can be an ideal target for a short seller. While short sales can be profitable under the right circumstances, they should be approached carefully by experienced investors who have done their homework on the company they are shorting. Both fundamental and technical analysis can be useful tools in determining when it is appropriate to sell short.

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