In finance, short selling also known as shorting or going short is the practice of selling securities or other financial instruments that are not currently owned usually borrowed , and subsequently repurchasing them "covering".

In the event of an interim price decline, the short seller profits, since the cost of re purchase is less than the proceeds received upon the initial short sale. Conversely, the short position closes out at a loss if the price of a shorted instrument rises prior to repurchase. Potential loss on a short sale is theoretically unlimited, as there is no theoretical limit to a rise in the price of the instrument.

However, in practice, the short seller is required to post margin or collateral to cover losses, and inability to do so in a timely way would cause its broker or counterparty to liquidate the position.

In the securities markets, the seller generally must borrow the securities to effect delivery in the short sale. In some cases, the short seller must pay a fee to borrow the securities and must additionally reimburse the lender for cash returns the lender would have received had the securities not been loaned out. Short selling is most commonly done with instruments traded in public securities, futures or currency markets , due to the liquidity and real-time price dissemination characteristic of such markets and because the instruments defined within each class are fungible.

In practical terms, "going short" can be considered the opposite of the conventional practice of " going long ", whereby an investor profits from an increase in the price of the asset.

Mathematically, the return from a short position is equivalent to that of owning being "long" a negative amount of the instrument. Nevertheless, one main discrepancy in the short against a long position is that the short position must exclude the dividends paid, if any.

A short sale may have a variety of objectives. Speculators may sell short hoping to realize a profit on an instrument that appears overvalued, just as long investors or speculators hope to profit from a rise in the price of an instrument that appears undervalued.

Traders or fund managers may hedge a long position or a portfolio through one or more short positions.

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In contrast to a traditional merchant who starts out to "buy low, sell high", a short-seller starts out to "sell high, buy low", or even to "buy high, sell low" when this buy is in fact "on tick". Although some [ who? The following example describes the short sale of a security. To profit from a decrease in the price of a security, a short seller can borrow the security and sell it expecting that it will be cheaper to repurchase in the future.

When the seller decides that the time is right or when the lender recalls the securities , the seller buys equivalent securities and returns them to the lender. The process relies on the fact that the securities or the other assets being sold short are fungible ; the term "borrowing" is therefore used in the sense of borrowing cash, where different bank notes or coins can be returned to the lender as opposed to borrowing a car, where the same car must be returned.

A short seller typically borrows through a broker , who is usually holding the securities for another investor who owns the securities; the broker himself seldom purchases the securities to lend to the short seller.

In most market conditions there is a ready supply of securities to be borrowed, held by pension funds, mutual funds and other investors. The act of buying back the securities that were sold short is called "covering the short" or "covering the position". A short position can be covered at any time before the securities are due to be returned. Once the position is covered, the short seller is not affected by subsequent rises or falls in the price of the securities, as he already holds the securities required to repay the lender.

Short selling refers broadly to any transaction used by an investor to profit from the decline in price of a borrowed asset or financial instrument.

However some short positions, for example those undertaken by means of derivatives contracts , are not technically short sales because no underlying asset is actually delivered upon the initiation of the position. Derivatives contracts include futures , options , and swaps. Shares in ACME Inc. The practice of short selling was likely invented in by Dutch businessman Isaac Le Maire , a sizeable shareholder of the Vereenigde Oostindische Compagnie VOC. This, combined with the seemingly complex and hard-to-follow tactics of the practice, has made short selling a historical target for criticism.

The London banking house of Neal, James, Fordyce and Down collapsed in June , precipitating a major crisis that included the collapse of almost every private bank in Scotland, and a liquidity crisis in the two major banking centres of the world, London and Amsterdam.

The bank had been speculating by shorting East India Company stock on a massive scale, and apparently using customer deposits to cover losses. It was perceived [ citation needed ] as having a magnifying effect in the violent downturn in the Dutch tulip market in the eighteenth century. The term "short" was in use from at least the mid-nineteenth century. It is commonly understood that "short" is used because the short-seller is in a deficit position with his brokerage house.

Jacob Little was known as The Great Bear of Wall Street who began shorting stocks in the United States in Short sellers were blamed for the Wall Street Crash of Edgar Hoover said he would investigate short sellers for their role in prolonging the Depression. Negative news, such as litigation against a company, may also entice professional traders to sell the stock short in hope of the stock price going down. During the dot-com bubble , shorting a start-up company could backfire since it could be taken over at a price higher than the price at which speculators shorted.

During the financial crisis , critics argued that investors taking large short positions in struggling financial firms like Lehman Brothers , HBOS and Morgan Stanley created instability in the stock market and placed additional downward pressure on prices.

In response, a number of countries introduced restrictive regulations on short-selling in and Naked short selling is the practice of short-selling a tradable asset without first borrowing the security or ensuring that the security can be borrowed — it was this practice that was commonly restricted.

That ban expired several weeks later as regulators determined the ban was not stabilizing the price of stocks. Temporary short-selling bans were also introduced in the United Kingdom, Germany, France, Italy and other European countries in to minimal effect. Investors continue to argue this only contributes to market inefficiency.

Short selling stock works similar to buying on margin , therefore also requires a margin account as well:. To sell stocks short in the U. This is referred to as a locate.

Brokers have a variety of means to borrow stocks to facilitate locates and make good on delivery of the shorted security. The vast majority of stocks borrowed by U.

Institutions often lend out their shares to earn extra money on their investments. These institutional loans are usually arranged by the custodian who holds the securities for the institution.

The cash collateral is then invested by the lender, who often rebates part of the interest to the borrower. The interest that is kept by the lender is the compensation to the lender for the stock loan. Brokerage firms can also borrow stocks from the accounts of their own customers.

Typical margin account agreements give brokerage firms the right to borrow customer shares without notifying the customer. In general, brokerage accounts are only allowed to lend shares from accounts for which customers have debit balances , meaning they have borrowed from the account. SEC Rule 15c imposes such severe restrictions on the lending of shares from cash accounts or excess margin fully paid for shares from margin accounts that most brokerage firms do not bother except in rare circumstances.

These restrictions include that the broker must have the express permission of the customer and provide collateral or a letter of credit. Most brokers allow retail customers to borrow shares to short a stock only if one of their own customers has purchased the stock on margin.

Brokers go through the "locate" process outside their own firm to obtain borrowed shares from other brokers only for their large institutional customers. Stock exchanges such as the NYSE or the NASDAQ typically report the "short interest" of a stock, which gives the number of shares that have been legally sold short as a percent of the total float. Alternatively, these can also be expressed as the short interest ratio , which is the number of shares legally sold short as a multiple of the average daily volume.

These can be useful tools to spot trends in stock price movements but for them to be reliable, investors must also ascertain the number of shares brought into existence by naked shorters. Speculators are cautioned to remember that for every share that has been shorted owned by a new owner , a 'shadow owner' exists i. When a security is sold, the seller is contractually obliged to deliver it to the buyer. If a seller sells a security short without owning it first, the seller must borrow the security from a third party to fulfill its obligation.

Otherwise, the seller fails to deliver, the transaction does not settle , and the seller may be subject to a claim from its counterparty. Certain large holders of securities, such as a custodian or investment management firm, often lend out these securities to gain extra income, a process known as securities lending. The lender receives a fee for this service.

Similarly, retail investors can sometimes make an extra fee when their broker wants to borrow their securities. This is only possible when the investor has full title of the security, so it cannot be used as collateral for margin buying.

Time delayed short interest data for legally shorted shares is available in a number of countries, including the US, the UK, Hong Kong, and Spain. The number of stocks being shorted on a global basis has increased in recent years for various structural reasons e. The data is typically delayed; for example, the NASDAQ requires its broker-dealer member firms to report data on the 15th of each month, and then publishes a compilation eight days later.

Some market data providers like Data Explorers and SunGard Financial Systems [26] believe that stock lending data provides a good proxy for short interest levels excluding any naked short interest. SunGard provides daily data on short interest by tracking the proxy variables based on borrowing and lending data it collects.

Days to Cover DTC is a numerical term that describes the relationship between the number of shares in a given equity that has been legally short-sold and the number of days of typical trading that it would require to 'cover' all legal short positions outstanding. For example, if there are ten million shares of XYZ Inc. Short Interest is a numerical term that relates the number of shares in a given equity that have been legally shorted divided by the total shares outstanding for the company, usually expressed as a percent.

If however, shares are being created through naked short selling, "fails" data must be accessed to assess accurately the true level of short interest.

Borrow cost is the fee paid to a securities lender for borrowing the stock or other security. However, certain stocks become "hard to borrow" as stockholders willing to lend their stock become more difficult to locate. A naked short sale occurs when a security is sold short without borrowing the security within a set time for example, three days in the US. This means that the buyer of such a short is buying the short-seller's promise to deliver a share, rather than buying the share itself.

The short-seller's promise is known as a hypothecated share. When the holder of the underlying stock receives a dividend, the holder of the hypothecated share would receive an equal dividend from the short seller. Naked shorting has been made illegal except where allowed under limited circumstances by market makers. In the US, arranging to borrow a security before a short sale is called a locate.

In , to prevent widespread failure to deliver securities, the U. Securities and Exchange Commission SEC put in place Regulation SHO , intended to prevent speculators from selling some stocks short before doing a locate. Requirements that are more stringent were put in place in September , ostensibly to prevent the practice from exacerbating market declines.

The rules were made permanent in When a broker facilitates the delivery of a client's short sale, the client is charged a fee for this service, usually a standard commission similar to that of purchasing a similar security. If the short position begins to move against the holder of the short position i.

If short shares continue to rise in price, and the holder does not have sufficient funds in the cash account to cover the position, the holder begins to borrow on margin for this purpose, thereby accruing margin interest charges.

These are computed and charged just as for any other margin debit. Therefore, only margin accounts can be used to open a short position. When a security's ex-dividend date passes, the dividend is deducted from the shortholder's account and paid to the person from whom the stock is borrowed. For some brokers, the short seller may not earn interest on the proceeds of the short sale or use it to reduce outstanding margin debt.

These brokers may not pass this benefit on to the retail client unless the client is very large. The interest is often split with the lender of the security. Where shares have been shorted and the company that issues the shares distributes a dividend, the question arises as to who receives the dividend.

The new buyer of the shares, who is the holder of record and holds the shares outright, receives the dividend from the company. However, the lender, who may hold its shares in a margin account with a prime broker and is unlikely to be aware that these particular shares are being lent out for shorting, also expects to receive a dividend. The short seller therefore pays the lender an amount equal to the dividend to compensate—though technically, as this payment does not come from the company, it is not a dividend.

The short seller is therefore said to be short the dividend. A similar issue comes up with the voting rights attached to the shorted shares. Unlike a dividend, voting rights cannot legally be synthesized and so the buyer of the shorted share, as the holder of record, controls the voting rights. The owner of a margin account from which the shares were lent agreed in advance to relinquish voting rights to shares during the period of any short sale. As noted earlier, victims of naked shorting sometimes report that the number of votes cast is greater than the number of shares issued by the company.

When trading futures contracts , being 'short' means having the legal obligation to deliver something at the expiration of the contract, although the holder of the short position may alternately buy back the contract prior to expiration instead of making delivery.

Short futures transactions are often used by producers of a commodity to fix the future price of goods they have not yet produced. Shorting a futures contract is sometimes also used by those holding the underlying asset i.

Shorting futures may also be used for speculative trades, in which case the investor is looking to profit from any decline in the price of the futures contract prior to expiration. An investor can also purchase a put option, giving that investor the right but not the obligation to sell the underlying asset such as shares of stock at a fixed price. In the event of a market decline, the option holder may exercise these put options, obliging the counterparty to buy the underlying asset at the agreed upon or "strike" price, which would then be higher than the current quoted spot price of the asset.

Selling short on the currency markets is different from selling short on the stock markets. Currencies are traded in pairs, each currency being priced in terms of another. In this way, selling short on the currency markets is identical to going long on stocks. Novice traders or stock traders can be confused by the failure to recognize and understand this point: When the exchange rate has changed, the trader buys the first currency again; this time he gets more of it, and pays back the loan.

Since he got more money than he had borrowed initially, he makes money. Of course, the reverse can also occur. An example of this is as follows: Let us say a trader wants to trade with the US dollar and the Indian rupee currencies. Assume that the current market rate is USD 1 to Rs. With this, he buys USD 2.

If the next day, the conversion rate becomes USD 1 to Rs. One may also take a short position in a currency using futures or options; the preceding method is used to bet on the spot price, which is more directly analogous to selling a stock short.

Short selling is sometimes referred to as a "negative income investment strategy" because there is no potential for dividend income or interest income. Stock is held only long enough to be sold pursuant to the contract, and one's return is therefore limited to short term capital gains , which are taxed as ordinary income.

For this reason, buying shares called "going long" has a very different risk profile from selling short. Furthermore, a "long's" losses are limited because the price can only go down to zero, but gains are not, as there is no limit, in theory, on how high the price can go. On the other hand, the short seller's possible gains are limited to the original price of the stock, which can only go down to zero, whereas the loss potential, again in theory, has no limit.

For this reason, short selling probably is most often used as a hedge strategy to manage the risks of long investments. Many short sellers place a stop order with their stockbroker after selling a stock short—an order to the brokerage to cover the position if the price of the stock should rise to a certain level.

This is to limit the loss and avoid the problem of unlimited liability described above. In some cases, if the stock's price skyrockets, the stockbroker may decide to cover the short seller's position immediately and without his consent to guarantee that the short seller can make good on his debt of shares. Short sellers must be aware of the potential for a short squeeze. When the price of a stock rises significantly, some people who are shorting the stock cover their positions to limit their losses this may occur in an automated way if the short sellers had stop-loss orders in place with their brokers ; others may be forced to close their position to meet a margin call ; others may be forced to cover, subject to the terms under which they borrowed the stock, if the person who lent the stock wishes to sell and take a profit.

Since covering their positions involves buying shares, the short squeeze causes an ever further rise in the stock's price, which in turn may trigger additional covering. Because of this, most short sellers restrict their activities to heavily traded stocks, and they keep an eye on the "short interest" levels of their short investments. Short interest is defined as the total number of shares that have been legally sold short, but not covered.

A short squeeze can be deliberately induced. This can happen when large investors such as companies or wealthy individuals notice significant short positions, and buy many shares, with the intent of selling the position at a profit to the short sellers, who may be panicked by the initial uptick or who are forced to cover their short positions to avoid margin calls. Another risk is that a given stock may become "hard to borrow.

Additionally, a broker may be required to cover a short seller's position at any time "buy in". The short seller receives a warning from the broker that he is "failing to deliver" stock, which leads to the buy-in.

Because short sellers must eventually deliver the shorted securities to their broker, and need money to buy them, there is a credit risk for the broker. The penalties for failure to deliver on a short selling contract inspired financier Daniel Drew to warn: In , the eruption of the massive China stock frauds on North American equity markets brought a related risk to light for the short seller.

The efforts of research-oriented short sellers to expose these frauds eventually prompted NASDAQ, NYSE and other exchanges to impose sudden, lengthy trading halts that froze the values of shorted stocks at artificially high values. Reportedly in some instances, brokers charged short sellers excessively large amounts of interest based on these high values as the shorts were forced to continue their borrowings at least until the halts were lifted.

Short sellers tend to temper overvaluation by selling into exuberance. Likewise, short sellers are said to provide price support by buying when negative sentiment is exacerbated after a significant price decline. Short selling can have negative implications if it causes a premature or unjustified share price collapse when the fear of cancellation due to bankruptcy becomes contagious. Hedging often represents a means of minimizing the risk from a more complex set of transactions.

Examples of this are:. A short seller may be trying to benefit from market inefficiencies arising from the mispricing of certain products. Examples of this are. One variant of selling short involves a long position. The term box alludes to the days when a safe deposit box was used to store long shares.

The purpose of this technique is to lock in paper profits on the long position without having to sell that position and possibly incur taxes if said position has appreciated. Once the short position has been entered, it serves to balance the long position taken earlier.

Thus, from that point in time, the profit is locked in less brokerage fees and short financing costs , regardless of further fluctuations in the underlying share price. For example, one can ensure a profit in this way, while delaying sale until the subsequent tax year.

Unless certain conditions are met, the IRS deems a "short against the box" position to be a "constructive sale" of the long position, which is a taxable event. These conditions include a requirement that the short position be closed out within 30 days of the end of the year and that the investor must hold their long position, without entering into any hedging strategies, for a minimum of 60 days after the short position has been closed.

The Securities and Exchange Act of gave the Securities and Exchange Commission the power to regulate short sales. The uptick rule aimed to prevent short sales from causing or exacerbating market price declines. Regulation SHO was the SEC's first update to short selling restrictions since the uptick rule in The regulation contains two key components: The close out component requires that a broker be able to deliver the shares that are to be shorted.

This mechanism is in place to ensure a degree of price stability during a company's initial trading period. However, some brokerage firms that specialize in penny stocks referred to colloquially as bucket shops have used the lack of short selling during this month to pump and dump thinly traded IPOs.

Canada and other countries do allow selling IPOs including U. The Securities and Exchange Commission initiated a temporary ban on short selling on financial stocks from 19 September until 2 October Greater penalties for naked shorting, by mandating delivery of stocks at clearing time, were also introduced. Some state governors have been urging state pension bodies to refrain from lending stock for shorting purposes.

In the UK, the Financial Services Authority had a moratorium on short selling 29 leading financial stocks, effective from GMT , 19 September until 16 January Between 19 and 21 September , Australia temporarily banned short selling, [45] and later placed an indefinite ban on naked short selling. Advocates of short selling argue that the practice is an essential part of the price discovery mechanism.

Such noted investors as Seth Klarman and Warren Buffett have said that short sellers help the market. Klarman argued that short sellers are a useful counterweight to the widespread bullishness on Wall Street, [53] while Buffett believes that short sellers are useful in uncovering fraudulent accounting and other problems at companies.

Shortseller James Chanos received widespread publicity when he was an early critic of the accounting practices of Enron. Commentator Jim Cramer has expressed concern about short selling and started a petition calling for the reintroduction of the uptick rule.

Wright suggest Cramer exaggerated the costs of short selling and underestimated the benefits, which may include the ex ante identification of asset bubbles. Individual short sellers have been subject to criticism and even litigation. Asensio , for example, engaged in a lengthy legal battle with the pharmaceutical manufacturer Hemispherx Biopharma.

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Retrieved 25 December Hard to Borrow Securities" PDF. Retrieved 4 December Securities and Exchange Commission. SEC 11 April Key Points about Regulation SHO". Everything You Need to Know Explained Simply". Atlantic Publishing Group Inc.

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Economic history Private equity and venture capital Recession Stock market bubble Stock market crash. Within the time to delivery, the brokerage lends money using the bought security as collateral, and the stock is bought with borrowed money. Within the time to delivery, the brokerage lends the stock, using the sale amount and deposited margin as collateral, and the borrowed stock is sold.

If the stock price drops such that the value is below maintenance margin, the buyer has to deposit additional fund to cover it, otherwise forced selling may happen. If the stock price rises such that the value is below maintenance margin, the buyer has to deposit additional fund to cover it, otherwise forced buying may happen. To close the position, the buyer sells the stock to repay the loan in cash, pocketing the price difference between the buying price and the selling price.

To close the position, the seller buys the stock to repay the loan in stock, pocketing the price difference between the selling price and the buying price.

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