Subject: Trading - Shorting Stocks

Last-Revised: 9 Mar 2000
Contributed-By: Art Kamlet (artkamlet at aol.com), Rich Carreiro (rlcarr at animato.arlington.ma.us)

Shorting means to sell something you don't own.

If I do not own shares of IBM stock but I ask my broker to sell short 100 shares of IBM I have committed shorting. In broker's lingo, I have established a short position in IBM of 100 shares. Or, to really confuse the language, I hold 100 shares of IBM short.

Why would you want to short?

Because you believe the price of that stock will go down, and you can soon buy it back at a lower price than you sold it at. When you buy back your short position, you "close your short position."

The broker will effectively borrow those shares from another client's account or from the broker's own account, and effectively lend you the shares to sell short. This is all done with mirrors; no stock certificates are issued, no paper changes hands, no lender is identified by name.

My account will be credited with the sales price of 100 shares of IBM less broker's commission. But the broker has actually lent me the stock to sell. No way is he going to pay interest on the funds from the short sale. This means that the funds will not be swept into the customary

money-market account. Of course there's one exception here: Really big spenders sometimes negotiate a full or partial payment of interest on short sales funds provided sufficient collateral exists in the account and the broker doesn't want to lose the client. If you're not a really big spender, don't expect to receive any interest on the funds obtained from the short sale.

If you sell a stock short, not only will you receive no interest, but also expect the broker to make you put up additional collateral. Why? Well, what happens if the stock price goes way up? You will have to assure the broker that if he needs to return the shares whence he got them (see "mirrors" above) you will be able to purchase them and "close your short position." If the price has doubled, you will have to spend twice as much as you received. So your broker will insist you have enough collateral in your account which can be sold if needed to close your short position. More lingo: Having sufficient collateral in your account that the broker can glom onto at will, means you have "cover" for your short position. As the price goes up you must provide more cover.

When you short a stock you are essentially creating a new shareholder. The person who held the shares in a margin account (the person from whom the broker borrowed the shares on the short seller's behalf) considers himself or herself a shareholder, quite justifiably. The person who bought the (lent) shares from the the short seller also considers himself or herself a shareholder. Now what happens with the dividend and the vote? The company sure as heck isn't going to pay out dividends to all of these newly created shareholders, nor will it let them vote. It's actually fairly straightforward.

If and when dividends are paid, the short seller is responsible for paying those dividends to the fictitious person from whom the shares were borrowed. This is a cost of shorting. The short seller has to pay the dividend out of pocket. Of course the person who bought the shares might hold them in a margin account, so the shares might get lent out again, and so forth; but in the end, the last buyer in the chain of borrowing and shorting transactions is the one who will get the dividend from the company Tax-wise, a short seller's expense of paying a dividend to the lender is treated as a misc investment expense subject to the 2% of AGI floor. It does not affect basis (though I believe there is an exception that if a short position is open for 45 days or less, any dividends paid by the short seller are capitalized into basis instead of being treated as an investment expense -- check the latest IRS Pub 550).

Voting of shares is also affected by shorting. The old beneficial owner of a share (i.e., the person who lent it) and the new beneficial owner of the share both expect to cast the vote, but that's impossible--the company would get far more votes than shares. What I have heard is that in fact the lender loses his chance to vote the shares. The lender doesn't physically have the shares (he's not a shareholder of record) and the broker no longer physically has the shares, having lent them to the short seller (so the broker isn't a shareholder of record anymore, either). Only a shareholder-of-record can vote the shares, so that leaves the lender out. The buyer, however, does get to vote the shares. Implicit in this is that if you absolutely, positively want to guarantee your right to vote some shares, you need to ask your broker to journal them into the cash side of your account in time for the record date of the vote. If a beneficial owner whose broker lent out the shares accidentally receives the proxy materials (accidentally because the person is not entitled to them), the broker should have his computers set up to disallow that vote.

Even if you hold your short position for over a year, your capital gains are taxed as short-term gains.

A short squeeze can result when the price of the stock goes up. When the people who have gone short buy the stock to cover their previous short-sales, this can cause the price to rise further. It's a death spiral - as the price goes higher, more shorts feel driven to cover themselves, and so on.

You can short other securities besides stock. For example, every time I write (sell) an option I don't already own long, I am establishing a short position in that option. The collateral position I must hold in my account generally tracks the price of the underlying stock and not the price of the option itself. So if I write a naked call option on IBM November 70s and receive a mere $100 after commissions, I may be asked to put up collateral in my account of $3,500 or more! And if in November IBM has regained ground and is at $90, I would be forced to buy back (close my short position in the call option) at a cost of about $2000, for a big loss.

Selling short is seductively simple. Brokers get commissions by showing you how easy it is to generate short term funds for your account, but you really can't do much with them. My personal advice is if you are strongly convinced a stock will be going down, buy the out-of-the-money put instead, if such a put is available.

A put's value increases as the stock price falls (but decreases sort of linearly over time) and is strongly leveraged, so a small fall in price of the stock translates to a large increase in value of the put.

Let's return to our IBM, market price of 66 (ok, this article needs to be updated). Let's say I strongly believe that IBM will fall to, oh, 58 by mid-November. I could short-sell IBM stock at 66, buy it back at 58 in mid-November if I'm right, and make about net $660. If instead it goes to 70, and I have to buy at that price, then I lose net $500 or so. That's a 10% gain or an 8% loss or so.

Now, I could buy the IBM November 65 put for maybe net $200. If it goes down to 58 in mid November, I sell (close my position) for about $600, for a 300% gain. If it doesn't go below 65, I lose my entire 200 investment. But if you strongly believe IBM will go way way down, you should shoot for the 300% gain with the put and not the 10% gain by shorting the stock itself. Depends on how convinced you are.

Having said this, I add a strong caution: Puts are very risky, and depend very much on odd market behavior beyond your control, and you can easily lose your entire purchase price fast. If you short options, you can lose even more than your purchase price!

One more word of advice. Start simply. If you never bought stock start by buying some stock. When you feel like you sort of understand what you are doing, when you have followed several stocks in the financial section of the paper and watched what happens over the course of a few months, when you have read a bit more and perhaps seriously tracked some important financials of several companies, you might -- might -- want to expand your investing choices beyond buying stock. If you want to get into options (see the article on options), start with writing covered calls. I would place selling stock short or writing or buying other options lower on the list -- later in time.

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