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SellingShort
Mostinvestorsmakemoneybybuyingasecurityatalowprice,thensellingitlaterforahigher
price.Owningasecurityishavingalong positioninthatsecurity.Selling shortisaway
toprofitwhenthesecuritiesdeclineinprice,byborrowingthesecurities,sellingit,thenhopingto
beabletobuyitbacklateratalowerpricetoreplacethesecuritiesborrowed.However,ifthe
securitiespayadividendorinterestbeforetheshortiscovered,thentheshortsellermustpay
thoseamountstothelenderofthesecurities.
Inordertoborrowthesecuritiestosellshort,thebrokermaylendoutsecuritiesfromthe
brokerage'sowninventory,orfromthatofanotherbrokerage,orhemaylendoutsecuritiesheld
inthemarginaccountsofotherinvestors.Ifthebrokerisunabletoborrowthesecurities,as
sometimeshappenswithilliquidsecurities,forinstance,thenthesecuritycannotbesoldshort.
Abrokercanlendoutsecuritiesfromthemarginaccountsofotherinvestors,becausethe
standard margin agreementallowsit.Whenaninvestoropensamarginaccountata
brokerage,anysecuritiesboughtfortheaccountareheldinthestreet name,thenameofthe
brokerageforthebeneficialinterestoftheinvestorandascollateralforanyborrowing.The
standardmarginagreementallowsthebrokertolendoutthesecuritiesheldinitsmarginaccounts
toshortsellers.Andsincemarginisrequiredtosellshort,theinvestormusthaveamargin
account.

Ex amples

Example1ProfitsandLossesfromSellingShort.
Aninvestorborrows 100sharesofXYZstock thatiscurrentlytradingat $35pershare and
paysa 4%dividend ,andsellsit.Assumethatthestockpaida dividendof$1.40pershare
beforetheshortsellercoveredhisshort.Thisputs $3,500 intheshortsellersmarginaccount,of
which $140 willeventuallybedeductedtopayforthedividend.Ifthepricesubsequentlydeclines
to $30 ,theinvestorcanbuyitbackfor $3,000 toreturntheborrowedshares,thuscoveringthe
short position,andnetting $500 $140 = $360 fromthetrade.If,however,thepriceof
GMstockrisesto $40 ,thentheshortsellerwillhavetobuybackthestockfor $4,000 ,resulting
inanetlossof $500 + $140 = $640 .Brokeragecommissionsmustalsobesubtractedfromany
profitoraddedtoanyloss.Notethatforthesamepricemovementofthestock,the lossfroman
unfavorablemove ismuchgreaterthanthe profitgainedfromafavorablemove .

Before1998,manyinvestorssoldshortstocksthattheyactuallyownedselling short
against the boxasameanstoprotectcapitalgains,ortoconvertashorttermgainintoa
longtermgain,whichhasalowertaxrate.However,thismethodhasbeenrenderedineffective
bytheTaxpayer Relief Act of 1997.AnyshortsaleagainsttheboxafterJune8,1997,is
consideredaconstructive salebytheIRS,andissubjecttoacapitalgainstaxintheyearof
thesale.
Alargeinvestormayalsosellshortagainsttheboxtopreventthedisclosureofownershipinthe
security.

CalculatingtheRateofReturnforaShortSale
Althoughashortsellerreceivesmoneyfromashortsale,theshortsellermustpostanadditional
marginrequirementthatistypicallyequaltoofthevalueoftheshortedstock.Soif$10,000of
stockisshorted,thentheshortsellermusthaveatleast$5,000inhisaccounttocoverhisliability
fortheshortsale.Hence,rightaftertheshortsale,theshortsellerwouldhaveatleastatotalof
$15,000incashorequityinhisaccount.
Therateofreturnforashortsaleiscalculatedbythefollowingformula:
RateofReturnforaShortSaleFormula
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ShortRateofReturn =

StockSalePriceDividendsPaidStockPurchasePrice
InitialMarginRequirement

SotherateofreturninExample1fortheprofitableinvestmentis( $3,500 $140 $3,000 )/

$1,750= $360 /$1,750=20.57%,whilethereturnofreturnfortheinvestmentloss= $640 /
$1,750=36.57%.

Margin
Shortsalescanonlybemadefromamarginaccount.Typically,amarginaccountallowsthe
accountholdertoborrowupto50%oftheequityintheaccountforthepurchaseofnew
securities.Thereisalsoamaintenance requirementthatistypically30%oftheequity.If
thevalueoftheequitydropsbelow30%ofthetotalamount,thenthebrokerissuesamargin
call.Theinvestoreitherhastosendmorecashorotherequity,orthebrokerwillsellenoughof
thesecurities,toincreasethetotalequitybackto50%.Thus,iftheinvestorinitiallydeposits
$5,000intoanewmarginaccount,hecanbuyupto$10,000worthofstocks.Ifthevalueof
thosestockssubsequentlydeclinestobelow$7,000,thentheinvestorwillbesubjecttoamargin
call,because$2,000iswhatremainsoftheinvestor'sequity,whichislessthan30%ofthetotal
amountintheaccount.Hewillhavetodepositanother$1,500tobringtheequitytobackto50%.
ThemarginandthemarginmaintenancerequirementarespecifiedbyRegulation T,enacted
bytheFederal Reserve Board.CurrentlyRegulationTrequiresaninitialdepositof$2,000
ormoreforamarginaccount,and,initially,50%ormoreincashoreligiblesecuritiesassecurity
foranyborrowingtobuysecurities.Asappliedtoashortsale,theinvestormusthaveatleast
50%oftheshortsaleproceedsinequity.Brokersmayestablishmorestringentrequirements.
Inashortsale,moneyisdepositedintotheshortseller'saccount,butthismoneyisborrowed,
becausetheyaretheproceedsofborrowedsharesthatweresold,andtherefore,thismoneyearns
nointerestfortheaccountholder.Thus,insteadofsecurities,theshortsellerhasborrowedmoney
inhisaccount,whichissubjecttothesamemarginrestrictionsasbuyingstock.Theamountof
shortsalesproceedsdoesn'tchangeafterthesale,butthepriceoftheborrowedsecuritydoes,and
marginrequirementsaretiedtothepriceoftheshortedsecurity,notthemoneyintheaccount,
because,eventually,theshortedsecuritieswillhavetobeboughttoreplacetheborrowedshares.
Therefore,the current margin of the account is dependent on the current
market price of the shorted security because the short seller has a legal
obligation to buy back and return the securities that were borrowed.
Theequityofashortaccountisequaltotheamountondepositminusthecurrentvalueofthe
shortedsecurity:
Equity=AccountValueMarketValueofShortedSecurity

Theshortselleralsohasanobligationtopayanydividendstotheshareholderoftheborrowed
stocks,andsinceneitherthelendernortheshortsellerownstheshortedstock,neitherreceivethe
dividendspaidbythecorporation,butthelenderisstillentitledtodividendpayments,sothe
shortsellermustpaywhatisknownassubstitute payments in lieu of dividendstothe
stocklender.Thebrokerpaysthisautomaticallyfromtheshortseller'saccount,whichdecreases
theamountondeposit,andtherefore,theshortseller'sequityandmargin.

Ex amples

ExampleCalculatingtheEquityofaShortAccount
Ifyoudeposit$5,000andsell 1,000sharesofXYZstock shortfor $10pershare ,thenthereis
$15,000ondeposit inyouraccount,butyour equity isstill $15,000 $10,000 = $5,000 ,
whichis,ofcourse,whatyouinitiallydeposited.
IfXYZpricerisesto $12pershare ,thenyourequity= $15,000 $12,000 = $3,000 .
IfXYZpricedropsto $8pershare ,thenyourequity= $15,000 $8,000 = $7,000 .
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Tocalculatemargin,justdivideequitybythemarketvalueoftheshortedsecurity:
CalculatingtheCurrentMarginofaShortAccount
Margin =

Equity CMV=CurrentMarketValueofShortedSecurity
CMV

MathNote:Multiplyfractionby100togetapercentage.

Ex amples

ExampleCalculatingtheCurrentMarginandCurrentEquityofaShort
Sale.
Youopenamarginaccountanddeposit $5,000 .Yousellshort 1,000shares XYZstockfor $10
pershare .Theproceedsofthesale, $10,000 ,isdepositedinyouraccount.Thereisnow
$15,000 inyouraccount.However,youstillonlyhave $5,000ofequity inyouraccount,because
the $10,000ofshortsaleproceeds isfromborrowedsecurities.
Scenario1Thestockpricedeclinesto $6pershare ,sothe1,000sharesthatyousoldshortis
currentlyworth $6,000 .Thus:
yourequity= $15,000 $6,000 = $9,000
yourmargin= $9,000 / $6,000 =1.5=150%
Thus,thisshortsalewouldbeprofitableifyouboughtbackthesharesnowtocoveryourshort,
foranetprofitof $4,000 minusbrokeragecommissionsandanydividendsthathadtobepaid
whilethestockwasborrowed.
Scenario2Thestockpricerisesto $12.00pershare ,thusitwillcostyou $12,000 tobuy
backthesharesnow.
yourequity= $15,000 $12,000 = $3,000
yourmargin= $3,000 / $12,000 =.25=25%
Becauseyourcurrentmarginisnowlessthan30%,youwillbesubjectedtoamargincall.Ifyou
decidetobuybackthesharesnowtocoveryourshort,your netlosswillbe$2,000 plus
brokeragecommissionsandanydividendsthathadtobepaidwhilethestockwasborrowed.

DeterminingtheValueofShortedSecuritiesThatWillElicitaMargin
Call
Theformulaforcalculatingthevalueofsecuritiesthatwillelicitamargincallforshortedstock
canbederivedfromtheformulaforcalculatingmargin:
1.
2.
3.
4.
5.
6.
7.
8.

Margin=(AccountValueValueofShortedSecurities)/ValueofShortedSecurities
Letm=marginratioa=accountvalueandv=valueofshortedsecurities.
m=(av)/v
m*v=avMultiplybothsidesbyv.
v+m*v=aAddvtobothsides.
v(1+m)=aFactoroutvfromtheleftside.
v=a/(1+m)Dividebothsidesby1+m.
ValueofShortedSecurities=AccountValue/(1+Margin)

Thus,theshortaccountvaluethatwilltriggeramargincallcanbecalculatedwiththefollowing
formula:
CalculatingtheMarginCallAccountValueofaShortedSecurity
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MarginCallAccountValue =

AccountValue
1+MMR

MMR=MarginMaintenanceRequirement(whichis
usually.3=30%).
PriceperShare=MarginCallAccountValue/Number
ofShares

Ex amples

ExampleCalculatingtheMarginCallPriceofaShortedSecurity
Usingtheaboveexample,whatmarketpriceoftheshortedsecuritywilltriggeramargincall?
The totalamountondepositintheaccountis$15,000 andthe marginmaintenance
requirementis30% .Therefore,themargincallvalue= 15,000 /(1+ .3 )= 15,000 / 1.3 =
$11,538.46 .Thisisequaltoaprice per shareof $11,538 / 1,000 = $11.54 (rounded)per
share.Soamargincallwillbetriggeredwhenthepriceoftheshortedsecurityrisesto $11.54 .
Toverify,wesubstitute $11,538.46 intothemarginformulaabove,andfindthat( 15,000
11,538.46 )/ 11,538.46 =0.30= 30% ,themarginmaintenancerequirement.Notethatifany
dividendswerepaidout,thiswouldhavetobesubtractedfromtheamountondeposit.

RestrictionsonSellingShorttheShortSaleRule
Sellingsecuritiestendstodecreasetheirpricebyincreasingsupplyandreducingdemand,so
shortsellerscanactuallydrivedownthepriceoftheborrowedstockthroughtheirshortsales.In
thepast,shortsellersformedpoolsforthispurpose.
Topreventthis,theSecuritiesandExchangeCommissionenactedtheshortsale rule,
alternatelyknownastheplus tickoruptick rule,whichrequiresthatastockcanonlybe
soldshortifthelasttransactionofthestockwasauptick,oranincreaseinprice,oriftherewas
nopricechangeinthelasttransaction,butthepreviouschangeinpricewasanuptick,whichis
knownasthezeroplus tick ruleorthezerouptick rule.
Thisruledoesnotgenerallyapplytoderivativesecuritiessecuritieswhosepricesdependon
anothersecurityorbasketofsecurities,suchasexchangetradedfunds.Althoughthecurrent
pricesofderivativesaredependentontheinstantaneousmarketsupplyanddemand,justlikeany
othersecurity,thepriceofderivativesisdeterminedbythepricesofthederivedsecurities.Ifthe
priceofthederivativefelltoofarbelowthepriceoftheunderlyingasset,theninvestorswould
seeitasabargainandbuyit,increasingthedemand,and,thus,itsprice.Incertaincases,
arbitrageurscantakeadvantageofanysignificantdifferentialinprices,which,ineffect,closes
thepricegapbetweenthesecurities.
Acompanyinsideralsomaynotsellshortthecompany'sstock,whichmakessense,since
allowingthiswouldallowcompanyinsiderstostealmoneyfrominvestorsofthecompany,by
sellingthestockshort,thenissuingbadnewstodrivedownthepriceofthestock.
News!

NewsUpdateShortSaleUptickRuleEliminated
On June 13, 2007, the Commission voted to remove the short sale uptick rule test of
Rule 10a1: http://www.sec.gov/news/digest/2007/dig062807.txt <
http://www.sec.gov/news/digest/2007/dig062807.txt >

NakedShortSelling
Naked short sellingissellingastockshortwithoutfirstborrowingit.Thisoftenresultsfrom
afailure to deliver(akafail)thecertificatestothebuyerofthestockatsettlement,whichis
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afailure to deliver(akafail)thecertificatestothebuyerofthestockatsettlement,whichis
theresultofinstitutionalfailuretoeffectthetransfer.However,marketmakersarepermittedtodo
somenakedshortsellingtoincreasetheliquidityofthemarketwhenitisdifficulttoborrowthe
stockquicklyenoughtosatisfymarketdemand.However,nakedshortsellingisillegalasa
meanstodrivedownstockpricesinordertobuyatabetterprice.

RisksofSellingShort
Thereareriskstosellingshort.Themostobviousriskisthatthestockpricecanriseandcontinue
torise.Thepriceofastockcanrisemuchhigherthanitcanfall,and,therefore,thepotentialfor
lossesismuchgreaterthanthepotentialforprofits.
Anotherriskisthattheshortsellermaybeforcedtobuybackthestock,becausethesharessold
shortwereborrowed,andthelendermayrequestthosesharesbackatanytime.Usuallythe
brokercanobtainothersharesfromotherinvestors,butifthesharesarescarce,suchasoccurs
withsecuritieswithlittlefloat,thenthebrokermayhavenochoicebuttobuybackthesharesat
thecurrentmarketprice.Sometimes,investorswhoarelonginastockwithalargeshortinterest
willbuymoreofthestock,orasktheirbrokertodelivertheactualstockcertificatestothem,in
thehopeofforcingtheshortsellerstocovertheirpositionbybuyingthestockbackthisis
calledashort squeeze.

ShortInterestSupposedIndicatorofMarketSentiments
Becauseinvestorssellshortsotheycanprofitbyexpectedpricedeclinesintheshortedsecurities,
ortheywanttohedgetheirpositionsbecausetheyatleastthinkapricedeclineisagood
possibility,manyinvestorslookatthetotalshortinterestasagoodindicatorofmarketsentiments.
Short interestisthetotalnumberofsharesthathavebeensoldshort,butnotrepurchased
yet,tocovertheshortpositionsonanexchange.TheNewYorkStockExchange(NYSE),
AmericanStockExchange(AMEX),andtheNASDAQreleasetheshortinterestvolumefortheir
exchangesbythemiddleofthemonth,andisreportedinTheWallStreetJournalaboutaweek
afterthat.
Theshortsale ratio(also,short ratio),isthetotalnumberofsharesshorted,butnot
covered,dividedbytheaveragedailyvolumeofallsharestradedontheexchange.

ShortRatio =

NumberofSharesShorted,butNotCovered
AverageDailyVolumeofAllSharesTradedonExchange

Notethatwhilethenumeratoroftheshortratioincreaseswithshortinterest,thedenominator,the
averagedailyvolumeforthatmonth,isnotrelatedtotheshortinterest,and,therefore,theshort
ratiomayactuallydeclinewhentheshortinterestincreases,whichwouldoccurwhentheaverage
dailyvolumeincreasesmorethantheshortinterestandviceversa.Note,also,that,forthesame
reason,theshortratiodoesnotquantifytheshortinterest.
News!

RealWorldExampleDivergenceofShortInterestandtheShortSaleRatio
On August 22, 2006, The Wall Street Journal reported that, for the month ending
August 15, 2006, the short interest on the NYSE increased from the mid-July total of
9,298,283,040 shares to 9,638,209,066 sharesan increase of about 3.7% but
the short ratio actually decreased from 6.1% to 5.9% for the same month.

Someinvestors,however,consideralargeshortinteresttobeabullishsign,becausetheshort
sellerswillhavetopurchasetheshortedsecurityatsomepoint,whichwilltendtoincreaseits
price.Thisissometimescalledtheshort interest theory,orthecushion theory.
Technicalanalystsconsiderashortpositionthatistwicetheaveragedailytradingvolumetobea
verybullishsign,andagoodpossibilityforashort
http://thismatter.com/money/stocks/sellingshort.htm

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verybullishsign,andagoodpossibilityforashort squeeze,whichresultswhenshortsellers
buytocovertheirposition,raisingthestockprice,which,inturn,causesmoreshortsellersto
covertheirpositions,therebyraisingthestockpriceevenmore.
Therearemorespecializedshortinterestratiosthatsomeinvestorsconsider.Theoddlot
shortsale ratio(akaoddlot selling indicator)isthetotalofoddlotshortsales
dividedbythetotaloddlotsales.

OddLotShortSaleRatio =

TotalOddLotShortSales
TotalOddLotSales

Thissupposedprognosticatorisbasedontheoddlot theory,whichisbasedonthe
suppositionthatpeoplewhobuyandselloddlots(lessthan100sharesoraroundlot)arenovice
investors,andareactingindirectoppositiontotruemarketconditions.Thus,whenoddlotselling
ishigh,thenthemarkethasbottomedout,andit'stimetobuy,andviceversa.Thereisnoreal
evidencethattheoddlottheoryistrue,butevenifitis,itmaybebecauseinvestorsbelievethatit
istrue,andactaccordingly.
Themember shortsale ratio,usingsimilar,speciousreasoning,issupposedtobethetrue
marketindicator,andtheremaybeagrainoftruthtothis.Afterall,ifanyonewouldknowthe
market,itwouldbethemembersoftheNYSEwhospecialists,floortraders,andoffthefloor
tradersspecializeintheparticularsecuritiesthattheysellshort.Themembershortsaleratiois
thetotalsharessoldshortintheaccountsoftheNYSEmembersin1weekdividedbythetotal
shortsalesoutstandinginthesameweek.

MemberShortSaleRatio =

TotalSharesShortedbyNYSEMembersin1Week
TotalShortSalesOutstandinginSameWeek

ThemembershortsaleratioispublishedweeklyinThe Wall Street Journaland

Barron's.
Thespecialist's shortsale ratioiscomputedinthesamewayasthemembershortsale
ratio,butonlyincludestheaccountsofthespecialistsontheNYSE.

SpecialistShortSaleRatio =

TotalSharesShortedbyNYSESpecialistsin1Week
TotalShortSalesOutstandinginSameWeek

Someshortsalesaremadetoprovideanorderlymarketinthesecuritiesassignedtothespecialist
oneoftheirdutiesbutmanyinvestors,especiallytechnicalinvestors,usethisasa
prognosticatorofthemarkets.

Informationisprovided'asis'andsolelyforeducation,notfortradingpurposesorprofessional
advice.
Copyright19822016byWilliamC.Spaulding<http://thismatter.com/about.htm>

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