Short Sales

A short sale allows investors to profit from a decline in a security's price. An investor borrows a share of stock from a broker and sells it. Later, the short seller must purchase a share of the same stock in the market in order to replace the share that was borrowed. This is called covering the short position. Table 3.10 compares stock purchases to short sales.

The short seller anticipates the stock price will fall, so that the share can be purchased at a lower price than it initially sold for; the short seller will then reap a profit. Short sellers must not only replace the shares but also pay the lender of the security any dividends paid during the short sale.

In practice, the shares loaned out for a short sale are typically provided by the short seller's brokerage firm, which holds a wide variety of securities in street name. The owner of the shares will not even know that the shares have been lent to the short seller. If the owner wishes to sell the shares, the brokerage firm will simply borrow shares from another investor. Therefore, the short sale may have an indefinite term. However, if the brokerage firm cannot locate new shares to replace the ones sold, the short seller will need to repay the loan immediately by purchasing shares in the market and turning them over to the brokerage firm to close out the loan.

Exchange rules permit short sales only when the last recorded change in the stock price is positive. This rule apparently is meant to prevent waves of speculation against the stock. In other words, the votes of "no confidence" in the stock that short sales represent may be entered only after a price increase.

Finally, exchange rules require that proceeds from a short sale must be kept on account with the broker. The short seller, therefore, cannot invest these funds to generate income. However, large or institutional investors typically will receive some income from the proceeds of a short sale being held with the broker. In addition, short sellers are required to post margin (which is essentially collateral) with the broker to ensure that the trader can cover any losses sustained should the stock price rise during the period of the short sale.5

To illustrate the actual mechanics of short selling, suppose that you are bearish (pessimistic) on IBM stock, and that its current market price is $100 per share. You tell your

5 We should note that although we have been describing a short sale of a stock, bonds also may be sold short.

CHAPTER 3 How Securities Are Traded 91

Table 3.10 Cash Flows from Purchasing versus Short Selling Shares of Stock

CHAPTER 3 How Securities Are Traded 91

Table 3.10 Cash Flows from Purchasing versus Short Selling Shares of Stock

Time

Action

Cash Flow

Purchase of Stock

0

Buy share

- Initial price

1

Receive dividend, sell share

Ending price + dividend

Profit =

(Ending price + dividend) - Initial price

Short Sale of Stock

0

Borrow share; sell it

+ Initial price

1

Repay dividend and buy share to

- (Ending price + dividend)

replace the share originally borrowed

Profit =

Initial price - (Ending price + dividend)

Note: A negative cash flow implies a cash outflow.

Note: A negative cash flow implies a cash outflow.

broker to sell short 1,000 shares. The broker borrows 1,000 shares either from another customer's account or from another broker.

The $100,000 cash proceeds from the short sale are credited to your account. Suppose the broker has a 50% margin requirement on short sales. This means that you must have other cash or securities in your account worth at least $50,000 that can serve as margin (that is, collateral) on the short sale. Let us suppose that you have $50,000 in Treasury bills. Your account with the broker after the short sale will then be:

Assets

Liabilities and Owner's Equity

Cash

$100,000

Short position in IBM stock

$100,000

T-bills

$50,000

(1,000 shares owed)

Equity

$50,000

Your initial percentage margin is the ratio of the equity in the account, $50,000, to the current value of the shares you have borrowed and eventually must return, $100,000:

Equity $50,000

s s Value of stock owed $100,000

Suppose you are right, and IBM stock falls to $70 per share. You can now close out your position at a profit. To cover the short sale, you buy 1,000 shares to replace the ones you borrowed. Because the shares now sell for $70, the purchase costs only $70,000. Because your account was credited for $100,000 when the shares were borrowed and sold, your profit is $30,000: The profit equals the decline in the share price times the number of shares sold short. On the other hand, if the price of IBM stock goes up while you are short, you lose money and may get a margin call from your broker.

Notice that when buying on margin, you borrow a given number of dollars from your broker, so the amount of the loan is independent of the share price. In contrast, when short selling you borrow a given number of shares, which must be returned. Therefore, when the price of the shares changes, the value of the loan also changes.

Let us suppose that the broker has a maintenance margin of 30% on short sales. This means that the equity in your account must be at least 30% of the value of your short position at all times. How far can the price of IBM stock go up before you get a margin call?

Let P be the price of IBM stock. Then the value of the shares you must return is 1,000P, and the equity in your account is $150,000 - 1,000P. Your short position margin ratio is therefore ($150,000 - 1,000P)/1,000P. The critical value of P is thus

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