Sunday, March 7, 2010

Short Selling Questions

This article will attempt to answer questions that you may have once you do start selling stocks short. We have already talked about what short selling is conceptually and here we will try to tackle questions regarding the actual mechanics of short selling.

I assume that you have carried out sufficient fundamental and/or technical analysis (depending on your trading style) and that you have already decided to take a short position.

Why do people consider short selling to be riskier than buying ("going long") stocks?
As with most things in the financial markets, the answer is yes and no. Theoretically at least it is true that short selling is inherently riskier. A stock can go higher indefinitely (making your potential loss infinite at least in theory) while it can only go down to zero on the downside (limiting your potential profit to 100%). In reality though, things are a little bit different (and more short selling-friendly) because of the following factors:
  • Although it is true that a stock has no limit as to how high it can get, in reality the value of a company (of which its stock price is a reflection, albeit one coloured by market psychology, overall trends, etc) will always be a finite number. This means that, although the payoff ratio for selling stocks short is asymetrical (you can lose more than you can make) in reality, the skew is not as pronounced, especially on a short-term timeframe.
  • Your trading or investment strategy should include a position sizing strategy. This will make a devastating loss to your portfolio highly unlikely. A position sizing strategy will limit the risk that you take on every trade or investment by sizing it so that the maximum loss that any individual position can sustain is tolerable for your portfolio so that in the long run you can be profitable even accounting for the losing investments or trades that you will inevitably go through.
  • Your short position should always include an explicit (at least in the beginning) stop loss price at which point your position will be closed out to prevent further losses. This will protect your capital in the long run (especially from the effects of one devastating trade or investment). In order to carry this out you can always place a buy to cover stop order at your stop loss price level. We'll talk about order types in a subsequent article.
  • Since shorting happens on a margin account, your broker will issue a margin call and liquidate your position when your funds go below the minimum margin requirement. Because of this, you will only lose the money in your account and not an unlimited amount.
  • The market is simply a reflection of several individual actions that market participants take in aggregate. On top of a fundamental and technical aspect, there is an emotional side to it so it is said that the market is driven by fear and greed; greed to make money and fear of losing it. Because of human nature, fear is the most powerful of the two so this results in the fact that normally (you will see this based on experience) markets fall much faster than they rise. Having the ability to short in your trading arsenal will allow you to take advantage of this and profit when the market is falling (rather than simply limiting losses which is the best a long-only portfolio can hope for in a falling market.
What type of account do I need in order to sell a stock short?
There are most likely two types of accounts that your broker will offer you: a cash and a margin account. In order to be able to short stocks you will need to have a margin account. This means that your account will be able to use funds loaned to you (at interest) by your broker. This is necessary for your broker to keep your short position open because you are going to borrow a stock, sell it and receive the proceeds from it but will still need to eventually "cover" this position by buying back to cover. Your broker will ensure that you will eventually cover your position by monitoring your margin (i.e. the collateral for your short position) and this is done through a margin account. In a cash account you can not sell short and you can not use margin to buy stock with borrowed funds. We will talk about margin in more detail in a subsequent article.

Can I short any stock I want to?
Your broker will indicate the restrictions that there are in terms of the stocks that you can short. For the most part, stocks with low stock prices will be difficult to short (or outright impossible to, depending on your broker). Also, there is a daily list of stocks that are "hard to borrow" and these ones might have additional restrictions (such as additional margin requirements). 

How do I actually short a stock?
Your broker's interface will include an optional similar to "Buy" or "Sell" which will be called something like "Short" or "Sell Short" along with "Buy to cover". This can be done over the phone as well, usually for an extra fee (because of the assistance)

What will happen when I hit the "short" button?
This varies depending on the broker but most will execute what is called a "Locate". A "Locate" is simply your broker trying to locate shares of the stock you want to short to ensure that your broker can actually borrow the stock for you to sell it and initiate the short transaction.

What if my broker does not have an inventory of stock for me to short?
Your broker in most cases has an internal inventory and when they execute a "locate" it will try to go externally to try and find the stock you want to short (so you can borrow the shares and sell them in the open market). If they can not locate the shares for you to short, the "locate" will fail and you will not be able to short.

When do I have to close out a short position?
A short position is closed out with a "buy to cover" transaction in most cases when you decide to. The only exceptions are when you are issued a "forced buy-in call" or a margin call that you didn't deposit additional funds into.

What is a "forced buy-in"?
When you initiated your short transaction, there were shares that were borrowed for you to be able to sell in the open market. Sometimes the lender of the shares will need their shares back and will call their shares back. Your broker will try to return said shares from another pool of willing lenders or from its own inventory but sometimes it will be necessary for you to buy back the shares so that they can be returned to the original lender. This is called a "forced buy-in" and is a risk you take on when initiating a short position. It is possible that your whole position or a portion of it is forced to be closed out (regardless of the current profit or loss on it). 

Another situation that can occur is that when the position was initiated, from the time when the locate was executed until the point in time where you sold short the inventory of stock might have run out. In such a situation, your initial short sale will go through and you will receive the proceeds and open a short position but your broker will not be able to deliver the shares to the buyer(s) and new shareholder(s) (i.e. whoever bought the shares you sold short). Your broker has 3 business days from the transaction date to deliver the shares to the other party. If it does not do so, there will be a "Fail to deliver" status on the transaction and your broker will issue a forced buy-in call that you will have to execute so that new shares are bought in the market and deliver to whoever bought your shares (from when you opened your short position originally). This will close out the transaction and might result in profit or loss to you depending on the price at which they were executed. Most brokers will issue the buy-in call and allow you a day or two for you to buy back the shares yourself so you have some control on the price (remember, this might be your whole position or only a portion of it). If you fail to do so though, your broker has the right to close out your short position (fully or partially).

How often are forced buy-in calls made?
In my personal experience, dealing with a large stock broker I have personally never been forced to close out a short position when it's not my intention. Keep in mind though, that short positions fit in my trading strategy only on a very short term basis (much shorter than when I am long). I have been told by my broker that it does not happen very often but they do have the right to force you to close out a short position. This can never happen to a long position, unless you are issued a margin call.

What is a margin call?
When you buy stock on margin (i.e. when your broker lends you money to buy stocks) you need to keep a percentage of the whole position in liquid assets (i.e. cash and marginable securities) to ensure that you will pay off the loan made to you. Since what you buy with the borrowed funds is actually a security that varies in price daily, there is a possibility that the money that was loaned to you was used to buy stocks that declined in price. When this happens, since the outstanding loan is for the same amount as originally and you have started to lose money, there might be a situation where your liquid assets (cash and marginable securities) become less than the minimum required. In this case your broker will issue a margin call, indicating to you that you should deposit additional cash and marginable securities to make up for the shortfall. If you fail to do so, your broker will close out your positions bought on margin at their convenience to recover the original loan made to you. 

Since shorting only takes place in a margin account, a losing trade (i.e. the stock starts going up) could erode your margin to keep the position open. If your margin goes below the minimum threshold, your broker will issue a margin call that if you don't respond to (or not fully) might entitle your broker to close out your short position as they see fit. 

What does my broker get when I sell short?
There is a commision per transaction that goes to your broker (when you open and when you close the position). Your broker will have to get the shares for you to sell on the open market so they need to borrow them from a willing lender (this is called securities lending -or sec lending- and is a way for a long-term shareholder to generate income from shares that will remain in the account by lending them out).

The way this works is that your broker will use the proceeds from the short sale as collateral that needs to be posted to the lender of the shares (i.e. you don't get any interest on the original proceeds of the sale, nor can you use them for anything). In fact, your broker will need to post 102% of the total market value of the borrowed shares and this is marked to market every day. If the position moves against you, your broker needs to post more collateral and this ties up more of your margin and might generate margin interest for you to be paid to your broker. The lender of the shares gets to invest this collateral at market rates and they get to keep the interest. At the same time, depending on how difficult it is to borrow a certain stock, they might pay your broker a "rebate" for facilitating the transaction so this is an incentive for your broker as well (the harder to borrow a stock it is, the less of a rebate they pay to your broker).

When the short position is closed out at a profit or at a loss the profit or loss is reflected in your account and the collateral is released to your broker and to your account.

What is the uptick rule?
In the past, you couldn't sell short when there was a down tick (i.e. the stock's last move in price was down in price). This was to prevent stocks that were already going down from going down even further because of short sellers. Starting in 2007 this rule was eliminated, although it might be reinstated either fully or in a modified version of it.

Is a profitable short position considered a capital gain?
Just like a long position any profits or losses you make (after you have closed out the position) are considered capital gains or losses and taxable as such. Furthermore, if you are in the US, short selling prodits are always considered short term capital gains and taxed as such. Canada does not make this distinction between short and long term capital gains. 

What happens to voting rights for shares that are sold short?
Normally, the shareholder lending out the shares will give up its voting rights to those shares while they are out on loan. This is dones so that the voting power is not artificially increased just because there are shares that are borrowed to be sold short. The new shareholder (the one who bought the shares sold short) will have all the voting rights that said shares entitles him/her to. If the original shareholder needs to exercise their voting rights then they would have to call back their shares and finalize the loan so they can use those shares to exercise their voting power. This is different than dividend rights since those usually stay with the original shareholder even while their shares are out on loan.

What happens to dividends and special distributions when a short position is open?
While a short position is open, there might be a scheduled dividend payment by the corporation to its shareholders or a special distribution of any kind (cash, stock, spin-offs, etc.). In this case, there are three participants, the original shareholder (who lent you their shares), the short seller (you), and the new shareholder (whoever bought the shares you sold short).

It is important that you understand that both the new and the original shareholders expect a dividend payments since the securities lending agreement usually doesn't give away the right to dividend and distributions that the original shareholder had. This is different than voting rights since those are normally transferred from the original shareholder lending out the shares to the new shareholder who bought the shares that were sold short.

Let's assume there is a scheduled dividend payment. This is the position of each participant:
  • The original shareholder (with their shares out on loan to you) expects a dividend
  • The new shareholder expects a dividend (since to them, the transaction is no different than an outright purchase of stock)
  • The short seller is holding the short position.
And this is what happens:
  • The dividend paid out by the corporation goes out to the new shareholder
  • The short seller has to pay out the dividend to the original shareholder.
  • The stock will usually adjust its price down by the amount of the dividend, benefiting the short seller.
The same thing would happen with any other distribution made by the corporation to its shareholders. The short seller would have the obligation to make those payments to the original shareholder to mirror those that the corporation is making to all its shareholders.