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Intro to stocks

Short Selling

Short selling has been defined as the sale of securities which the seller does not own. But how can someone sell a stock they do not own? Well the process is simple and outlined below:

  1. Contact your broker (discount or full service) and declare your intention to short a security

  2. Your broker will then loan you the securities out of its inventory

  3. Sell your borrowed securities into the market as you would with any other securities you own

  4. The proceeds of the short sale are deposited in your account

  5. Finally you must deposit the required margin in your account (detailed below)

Short selling is in fact the exact opposite of the normal process of purchasing shares on margin (taking a long position) and selling them at a later time in the market. As we have outlined above, the investor first sells the security with the intent to later buy it back at a lower price. Essentially, profits are made whenever the initial sale price (via the short sale) exceeds the subsequent purchase cost. As a result, in terms of transactions the strategy of short selling is the reverse of a regular or long position in the market. Short sellers are looking for investments (ex. stocks) which they believe are overpriced and have a good possibility of experiencing a price decline over time.

Because you are borrowing securities from your broker whenever you perform a short sale, you are required to maintain a minimum balance or margin amount in your account (surprise!). Below, we have constructed a table detailing the minimum credit balance requirements of Canadian Stock Exchanges and the Investment Dealers Association.

Minimum Credit Balance Requirements of the Exchanges and the IDA

On Listed Securities Selling: Minimum Margin Required
Option Eligible Securities 130% of market value
at $2.00 and over 150% of market value
at $1.50 to $1.99 $3.00 per share
at $0.25 to $1.49 200% of market value
under $0.25 100% of market + $0.25/shr

Remember that, for example the quoted figure of "130% of market value" refers to the current market value of the shares short sold. Therefore, if you were to short sell 1000 shares of option eligible company XYZ at $5.00, your account would receive the proceeds equal to $5,000. Thus, your minimum margin requirement would be 130% of this amount or $7500. Because the proceeds of the short sale ($5,000) are already in your account, you need only deposit the balance of the funds or $2,500 ($5,000 from short sale + $2,500 your margin).

Below, we have constructed a model short sale transaction, as well as the effects a price decline (Scenario 1) and a price increase (Scenario 2) have on your account.

Assume that you wish to sell short 1,000 of Company XYZ's shares at its current market price of $5.00. The following example calculates your margin requirement or the money you must put up at $2,500.

Account Balance: your minimum required account balance
(150% of $5.00 * 1,000 shares)
$7,500
Less: proceeds from your short sale
($5.00 * 1,000 shares)
$5,000
Equals: your minimum margin requirement $2,500

Scenario 1: Stock Price Drops (as a short seller, you actually like this!)

Assume that one month later Company XYZ's shares decline to $4.00. The following example calculates the excess margin or paper profit in your account on your original transaction above.

Account Balance: your minimum required account balance
(150% of $4.00 * 1,000 shares)
$6,000
Less: proceeds from your short sale
($5.00 * 1,000 shares)
$5,000
Equals: your minimum margin requirement $1,000
Original Margin: your original margin requirement above
(150% of $5.00 * 1,000 shares)
$2,500
Equals: your excess margin or paper profit $1,500

Scenario 2: Stock Price Rises (as a short seller, you do not like this!)

Assume that one month later Company XYZ's shares rise to $6.00. The following example calculates the margin call you will receive from your broker.

Account Balance: your minimum required account balance
(150% of $6.00 * 1,000 shares)
$9,000
Less: proceeds from your short sale above
($5.00 * 1,000 shares)
$5,000
Equals: your minimum margin requirement $4,000
Less: your original margin deposit
(150% of $5.00 * 1,000 shares)
$2,500
Equals: your margin deficiency
(additional amount you must deposit)
$1,500

Is there a time limit on short sales?

No! As long as an equivalent amount of the security you shorted remains in your brokers hands or can be borrowed from another brokerage and you maintain your required margin, you can short a stock for an indefinite period. You may be puzzled as to why another brokerage would loan your broker the securities you wish to short so your broker can lend them to you. Well, it is simple - the other brokerage gets to use your margin or the money you put up for the short sale free from any interest payment. The broker can then invest the margin and earn interest (free money!).

However, if your brokerage finds at any point that there is no longer replacement stock, it can borrow to continue to loan you for your short position in a stock or other security, then you will be required to buy the securities in the open market to cover your short sale. Although this situation is a relative rarity, it does happen and you should be aware of the possible consequences. If the particular shorted security in question happens to trade in low volumes, it may be difficult to purchase your shares without bidding up the price (remember you want to pay as little as possible). Therefore, when shorting stock, experienced investors tend to stick to shares in companies that trade in large volumes, have a large number of shares outstanding, and possess a significant number of shareholders.

A Danger of Short Selling

One danger of short selling is the theoretical possibility of an unlimited loss. As opposed to a long or regular purchase of shares in the open market on which you can only lose the amount of money you originally invested, there is no maximum loss that a short seller can occur. This is, of course, due to a fact that there is no limit to how high a stock can climb. For instance, if you were to short a stock trading at $5.00 and, due to some unforeseen occurrence, the stock surges to the $100 level and keeps on climbing; you will at some point be forced to cover your short position by buying back the shares somewhere past the $100 level (costing you over 20 times the original short sale proceeds). Sound Alarming? Probably.

Well, there are strategies many short sellers use to avoid such rare but potentially painful situations. One such strategy is to place a "stop buy" order with your broker at a certain price. Essentially, this order is set after a short sell at a price above the short price. You select this price to limit your potential losses if the stock rises suddenly. The order becomes active once the stock trades at its set price and your shares will be bought back to cover your short position at or around this price, limiting your potential loss.

Stock Strategies:


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