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4. Short Selling Strategies and Margin

5. Timing a Short Sale
6. Short Selling Analytics
7. Short Selling Alternatives
8. Risks of Short Selling
9. Ethics And The Role Of Short Selling

Short Selling Strategies and Margin

By
Elvis
Picardo,
CFA
Generally, the two main reasons to short are to either speculate or to hedge.

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Speculate
When you speculate
speculate,, you are watching for fluctuations in the market in order to quickly
make a big profit off of a high-risk investment. Speculation has been perceived negatively
because it has been likened to gambling. However, speculation involves a calculated
assessment of the markets and taking risks where the odds appear to be in your favor.
Speculating differs from hedging because speculators deliberately assume risk, whereas
hedgers seek to mitigate or reduce it. (For more insight, see What is the difference between
hedging and speculation?)
Speculators can assume a high loss if they use the wrong strategies at the wrong time, but
they can also see high rewards. Probably the most famous example of this was when George
Soros "broke the Bank of England" in 1992. He risked $10 billion that the British pound
would fall and he was right. The following night, Soros made $1 billion from the trade. His
profit eventually reached almost $2 billion. (For more on this trade, see The Greatest
Currency Trades Ever Made.)

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Speculators can benefit the market because they increase trading volume, assume risk and
add market liquidity. However, high amounts of speculative purchases can contribute to an
economic bubble and/or a stock market crash.

Hedge
For reasons we'll discuss later, very few sophisticated money managers short as an active
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investing strategy (unlike Soros). The majority of investors use shorts to hedge
hedge.. This means
they are protecting other long positions with offsetting short positions.
Hedging can be a benefit because you're insuring your stock against risk, but it can also be
expensive and a basis risk can occur. (To learn more about hedging, read A Beginner's Guide
To Hedging.)

Restrictions
Short selling is highly regulated by securities authorities around the world, not only because
of its risky nature, but also because it is prone to manipulation by dishonest short sellers who
may use unethical tactics to drive down stock prices. Such short and distort schemes and
other abuses such as bear raids are more prevalent during severe bear markets. Not
surprisingly, the two biggest recent changes in US short selling regulations Regulation SHO
and Rule 201 were implemented in the years after the tech wreck of 2000-02 and the

Trading Center

global bear market of 2008-09.

Regulation SHO
In January 2005, the SEC implemented Regulation SHO, which updated short sale regulations
that had been essentially unchanged since 1938. Regulation SHO specifically sought to curb
the practice of naked short selling,
selling, which had been rampant in the 2000-02 bear market.

Brooks Brothers Men's

Peal & Co....
Brooks Brothers OfficialTimeless Style, Always
Appropriate.

In a naked short sale, the seller does not borrow or arrange to borrow the shorted security in
time to make delivery to the buyer within the standard three-day settlement period.
(Remember that just as there is a seller on the other side of every buy transaction, there is a
buyer on the other side of every short sale trade). This results in the seller failing to deliver
the security to the buyer upon settlement, and is known as a failure
failure to deliver
deliver or fail in
short selling parlance. Such naked shorting can result in relentless selling pressure on
targeted stocks, and cause huge declines in their prices.
In order to address issues associated with failures
to deliver and curb naked short selling,
Regulation SHO imposed locate and close-out
requirements on broker-dealers for short sales.
(The locate requirement is discussed in the
Executing a Short Sale section of this tutorial.)
The close-out requirement is applicable to
securities in which there are a relatively
substantial number of extended failures to deliver
(known as threshold securities). Regulation
SHO requires broker-dealers to close out positions in threshold securities where failure-todeliver conditions have persisted for 13 consecutive settlement days.
days. Such closing out
requires the broker-dealer to buy back the shorted securities in the market, which may drive
up their prices and inflict significant losses on short sellers.

Rule 201
Short selling was synonymous with the uptick
uptick rule
rule for almost 70 years in the US. The rule
was implemented by the SEC in 1938 and required every short sale transaction to be entered
into at a price that was higher than the previous traded price, i.e., on an uptick. It was
designed to prevent short sellers from aggravating the downward momentum in a stock when
was already declining. The SEC repealed the uptick rule in July 2007. A number of market
experts believe this repeal contributed to the ferocious bear market and unprecedented
market volatility of 2008-09.

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In February 2010, the SEC adopted an alternative uptick rule also known as Rule 201
that restricts short selling by triggering a circuit breaker when a stock has dropped at least
10% in one day. The SEC said this would enable sellers of long positions to stand in the front
of the line and sell their shares before any short sellers once the circuit breaker is triggered.
With US and global equities recovering from a severe bear market at the time, the SEC also
said that the rule was intended to promote market stability and preserve investor confidence.

Short Selling and Margin

Short selling can generally only be undertaken in margin accounts,
accounts, which are accounts
offered by brokerages that allow investors to borrow money to trade securities. Because of
the higher degree of risk involved in short selling, the short seller has to ensure that he or she
has always has adequate capital (or margin) in the account to hold on to the short position.
Short selling is the mirror image of buying stocks on margin. Thus, since the short seller is
putting up less than the full value of the securities sold short, margin interest is charged by
the broker-dealer on the balance amount of the transaction.
Note that although the short seller receives an inflow of funds from the shares sold short,
these funds technically do not belong to the short seller, as they are obtained from the sale of
a borrowed asset. The short seller therefore has to deposit an additional amount in the
margin account as collateral for the short sale.
As with stocks purchased on margin, the margin requirement on short sales depends on the
price and quality of the stock, since these determine the risk associated with the short
position. Hence, blue-chip stocks with prices in the mid to high single digits have
substantially lower margin requirements than speculative small-cap stocks that trade in the
low single digits.
For instance, the margin requirement on a short sale may mandate that 150% of the value of
the short sale be held in a margin account when the short sale is made. Since 100% comes
from the short sale, the trader has to put up the balance 50% as margin.
Thus if a trader shorts 100 shares of a stock trading at $50, this margin requirement would
require the trader to deposit an additional $2,500 (50% of $5,000) as margin. This margin is
constantly monitored by the broker-dealer to ensure that it stays above the minimum
mandated level (known as the "maintenance
"maintenance margin")
margin") and would need to be topped up
without delay (the dreaded margin call) by the trader if the short sale does not work outif
the stock, instead of declining, appreciates significantly.
The following four points should be noted with regard to short sales in margin accounts:
1. The short seller does not receive interest on the proceeds of a short sale.
2. Margin maintenance requirements ensuring that there is adequate margin to hold on
to the short position are based on the current market price of the security, and not on
the initial price at which the security was sold short.
3. Margin requirements can be fulfilled through contributing cash or eligible securities to
the account.
4. If the short seller is unable to meet the margin requirements, the broker-dealer will
usually close out the short position at the prevailing market price, potentially saddling
the short seller with a huge loss.

Next: Timing a Short Sale

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4. Short Selling Strategies and Margin

5. Timing a Short Sale
6. Short Selling Analytics
7. Short Selling Alternatives
8. Risks of Short Selling
9. Ethics And The Role Of Short Selling

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