Short Selling Demystified – Clarification of Shorting Strategies

Short selling is an important finance concept, which although very basic, is sometimes misunderstood by students and CFA Level I candidates. We provide here a short explanation of short-selling.

Keep in mind that the implication of short selling differ depending on the asset. Lets jump right into it and start with the shorting of a stock.

Short selling a stock involves 2 simultaneous steps:

1)      Borrow the stock

2)      Immediately sell it on the market

Once the stock has been sold, the short-seller now owes that stock to whoever he borrowed it from (usually the broker). He must eventually purchase the shares back from the market and give it back to the lender. Hence the third step in the shorting process:

3)      Buy the stock back from the market (hopefully at a lower price) to give it back to the lender

Shorting dramatization not involving financial assets (just to make sure you fully grasp this important concept)

One day, I come up to you and ask you to lend me your new iPad with Retina display. Since you are a good friend, you agree. Like a total jerk, I then turn around and sell it on kijiji.com for $500. I now have $500 so I am pretty thrilled!
 
A few weeks later, you bump into me at the mall and ask me about your iPad. Even though you seem quite upset since I have obviously been screening your calls after selling your iPad, I keep my composure, smile and tell you Ill give it back tomorrow! I then run to the Apple Store and purchase a new iPad with Retina display with the same specifications. Luckily, Apple came out with a new model so this model is now only $300. I then give it back to you and I buy you a cappuccino to apologize for the delay! You are happy since you have an iPad back in mint condition and I am happier since I made $200 (less $5 for the cappuccino) off this transaction.

There are a few things to remember when shorting securities:

a)      Just like I bought a cappuccino in the above shorting dramatization, short-sellers have to pay interest on the proceeds from the sell. The rate charged is called the short rebate rate. For instance, in my example, I would be charged the short rebate rate on the $500.

b)      Short-sellers cannot go and spend the proceeds of their sale. The $500 I got from the iPad should remain in my account as collateral until I buy another one back so I would not be able to buy a new flat screen TV with the proceeds for example.

c)       If the stock shorted pays dividends, the short must pay them to the lender of the securities. The payment is called payment-in-lieu of dividends.

d)      In theory, since the price of a security can increase to infinity, the short-seller is exposed to infinite losses. If there was a war and most iPads get destroyed, I may have to spend $100,000 to purchase one and close out my short iPad position.

Please note that all these things (short rebate, proceeds frozen as collateral, dividend payment) occur automatically in the short-seller brokerage account. In real life, you do not have to actually do anything.

Another distinction causing confusion to some students is between selling and short-selling. Selling assumes you bought the asset previously and you therefore own it. A short-seller never actually owned the asset prior to selling; he borrows it from a broker. You sell a security to close a transaction which was opened when you bought the security.

You short-sell a security to open a transaction which will be closed later by buying the security. Basically, the order of the transaction differs: buy then sell vs. short sell then buy.

Shorting other assets

Shorting Bonds

The mechanics of shorting a bond is the same as shorting a stock. Borrow the bond, sell it and buy it back eventually. However, since most bonds trade over-the-counter and usually requires larger amounts of capital, only institutional investors typically short bonds. Retail investors forecasting an increase in interest rates (and therefore a decrease in bond prices) can either short a bond exchange-traded fund (ETF) or buy an inverse bond ETF.

Shorting Futures

The short party of the futures contract agrees to sell the underlying asset at the contracted future price.For example, if I were to short a June 2014 gold futures today (Oct. 4 2013) I would agree to sell gold for $1,313/ounce in June 2014. Unlike shorting stocks, the asset does not change hands at initiation of the contract, the only cash flow required is the margin that the investor needs to post in the investment account.

Shorting Options

Shorting of options also have different implications than shorting a stock of bond. Shorting an option means the same thing as writing an option and entails an obligation. Shorting a call obliges the person to sell the underlying asset to the long party at a specific price, should the long exercise his right. Shorting a put obliges the investor to buy the underlying asset from the long party should the long exercise. In other words, in an option transaction, the long side calls the shots and the short side has no choice but to act accordingly.

Shorting regulations

In various countries,there has been regulations aimed at limiting the use of short selling in order to avoid precipitous fall in the market price of securities. In the U.S. the uptick rule, which was abolished in 2007, prevented short-selling on a downtick. In the wake of the 2008 financial crisis, there were proposals to reintroduce the uptick rule in reaction to the large market decline. Short sellers have often been blamed, especially in European countries, for precipitous fall in stock market. According the the Economist, short-sellers are not to blame for falling markets and should not be hampered by cumbersome regulations.

On the other hand, naked short selling refers to the selling of a security without first borrowing it. This practice is not available to retail investors and is usually not allowed by regulators (SEC banned it in 2008).

We hope this clarified the mystical concept of short-selling which is one of the basic notion CFA candidates should fully grasp. If you have any comments or suggestions of topics for which you need clarification, we encourage you to contact us or leave a comment.

If you have not done so already, we invite you to check out our latest eBook Study Guide specifically tailored for the December 2013 CFA Level 1 exam. With over 400 pages of fresh content, this Guide is the ideal companion to your CFA Study Toolbox.

CFA Level 1 Study Guide