Short (finance)
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In finance, a short position makes a profit when the value of the underlying asset goes down.
A short position in a security, such as a stock or a bond, or equivalently to be short a security, means the holder of the position has sold a security that he does not own, with the intention to buy it back at a later time at a lower price. The short seller owes his broker and must repay the shortage when he covers his position. Technically, the broker usually in turn has borrowed the shares from some other investor who is holding his shares long; the broker itself seldom actually purchases the shares to loan to the short seller.[1]
Similarly, a short position in a futures contract, or to be short a futures contract, means the holder of the position has the obligation to sell the underlying asset at a later date.
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[edit] Short selling
[edit] History
Short selling has been a target of ire since at least the 18th century when England banned it outright. It was also considered a disreputable business practice because of the perceived magnifying effect it had on the violent downturn in the Dutch tulip market in the 17th century. Short sellers are widely regarded with suspicion because, to many people, they are profiting from the misfortune of others. However, academic studies have generally lauded short-selling as an important contribution to stock market efficiency.[2]
Political fallout from the Stock Market Crash of 1929 led the Congress of the United States to enact a law banning short sellers from selling shares during a down-tick. Legislation introduced in 1940 banned mutual funds from short selling. A few years later, in 1949, Alfred Winslow Jones founded an (unregulated) fund that bought stocks while selling other stocks short, hence hedging some of the market risk - the hedge fund was born.[citation needed]
On 2003-10-29 the SEC announced a one year pilot program to suspend the uptick rule for 1000 listed and NASDAQ traded stocks selected from the 3000 most liquid securities.[3]
[edit] Reasons for short selling
As with any trading strategy, short selling can have three underlying reasons.
Hedging, where the short seller wants to minimize an unwanted risk. Examples of this are
- a farmer who has only just planted his wheat and already wants to lock in the price at which he can sell after the harvest. He would take a short position in wheat futures.
- a market maker in corporate bonds is constantly trading bonds when clients want to buy or sell. This can create substantial bond positions. The largest risk is that interest rates overall move. The trader can hedge this risk by selling government bonds short against his long positions in corporate bonds. In this way, the risk that remains is credit risk of the corporate bonds.
Arbitrage, where the short seller tries to benefit from market inefficiencies arising from the mispricing of certain products. Examples of this are
- an arbitrageur who goes long futures contracts on a US Treasury security, and sells short the underlying US Treasury security.
Speculation, to follow
[edit] Securities lending
When you sell a security, you are contractually obliged to deliver it to the buyer. If you sell a security short, i.e. without owning it first, you will have to borrow it from a third party to fulfill your obligation. Otherwise, you will fail to deliver, the securities won't settle, and you can expect a claim from your counterparty. Certain large holders of securities, such as a custodian or investment management firm, often lend out these securities to gain extra income. This is called 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.
[edit] Naked short sale
A naked short sale is selling a security short, without first ensuring that you can in fact borrow the securities somewhere. In the US, locating the securities first is often referred to as a locate. To prevent widespread failure to deliver securities, the U.S. Securities and Exchange Commission (SEC) has put in place Regulation SHO which prevents investors from selling stocks short before doing a locate. Market makers do not have this restriction, as this would seriously restrict liquidity.
[edit] References
- ^ Understanding Short Selling - A Primer
- ^ Short Sale Constraints And Stock Returns by C.M Jones and O.A. Lamont
- ^ ORDER SUSPENDING THE OPERATION OF SHORT SALE PRICE PROVISIONS FOR DESIGNATED SECURITIES AND TIME PERIODS. Securities And Exchange Commission. Retrieved on January 6, 2007.
- http://mises.org/story/2527 Galles, Gary "Don't Sell Short Selling Short" Apr 6, 2007
