What is Short Selling | How Does Short Selling Work

Short selling is a process in which particular person borrows securities and sell them to any second person and buys the similar shares from third person eventually and then finally return back these identical shares to the original lender. It is also simply defined as selling borrowed shares. Since early 1600’s, the perception that someone can legitimately and profitably sell something in the market that is not owned by him has been working. At that time attempts had been made by the Dutch authorities to outlaw the short selling because it was creating market trouble for many people at that time.

Rationale

Mostly short sellers are bearish toward certain stock. If short seller makes it possible to borrow shares and sell them at $30, after few months the purchase of these shares at $23 results in a profit of $7. This means that rather than purchasing at low price and selling at higher price, the order of the two transactions is simply reversed by short seller. So in fact he sells first at higher price and buys later at a lower price and earns sufficient profit.

In the entire process of short selling, the original lender of shares is unknown. For example those investors are involved in the short selling process which has margin accounts at their brokerage houses. A hypothecation agreement is signed by an investor when he opens his brokerage account. This agreement allows the broker to lend the shares of any other individual. The investor has no concern with this arrangement because has the option to trade that shares along with the earning of dividends continuously.

Criticisms

In congress and smaller boardrooms discussions have been made for many years on the merits of short selling. People who favor the short selling argue that two types of activities are included in the margin trading. These two activities are selling short and buying on margin. The main purpose is to leverage the buying of shares. People in favor of short selling say that the responsibility of events promoting Great Crash of 1929 is largely on the shoulders of the margin buyers. Prices are up due to the speculative forces and hence the margin buying results in inflation. This influence is assisted by the short selling.

The opposition of short selling argued that it sometimes destabilizes the market because of its checkered heritage. There is a long memory of traders regarding short squeezes, manipulation and corners. It is the traditional demand of the people that the market become advance. Few people argued that prices declines as a result of short selling. They further said that short selling is evil because the downward pressure forced by short selling runs against the interests of the public.

How Does Short Selling Work

Mechanics of Short Selling

Besides the different opinions about short selling, it is clear fact that short selling is value able activity. A margin requirement must meet by short sellers because they understand that they are selling on margin. The investor who buys on margin need to pay certain interest but in case of shot selling no interest payment is made because money is not borrowed. The investor need to deposit money actually.

Suppose an investor is trading through Merrill Lynch purchases 100 shares of ABC in a margin account, and subsequently Merrill lends these shares to some other person who is also his client for the purpose of short selling. The short seller of those shares sells them at Kidder Peabody account.

The main point to remember here is that Merrill Lynch does not have any concern about final purchaser of these shares and also he is not informed about the purchasing transaction. The returning back of the borrowed shares after some future time is the only obligation of the short seller.

Also at the current moment of example, there are two investors who consider them as the sole owner of those shares. These owners are the lender who has purchased the shares in a margin account and the final purchaser who purchased the shares from the sort seller. According to industry practice, the short seller should pay the dividends to the lender. Short seller does not face loss in paying dividend because it is the tendency of the stock to decline on the ex-dividend day.

In some later future time the short seller purchase similar shares from any other person in order to returned back the borrowed shares to the lender. The short seller makes profit by buying the shares on a lower price than the selling price of the previously sold similar shares. Losses are also part of short sale which becomes very high when the prices of stock rise greatly and the short seller must repurchase the stock.

There is special trading restriction on most exchanges on short sale. Its execution is possible only on uptick. Uptick is related with the up change as the last stock price change. On the other hand downtick indicates the down change as the last stock price change. The tick depends on the changing of price minute by minute.   

Selling Short Against the Box

Another kind of short sale is against the box. In such transaction, short shares are sold by the investors that are owned simultaneously. The term box in the phrase indicates the safe deposit box where share certificate may present. The tax liability is shifted into future by the application of the strategy of selling short against the box.

A perfect hedge is created by the person who sells short against the box. The loss or gain in the sort position is exactly offset by any gain or loss associated with the stock. The reason for involving of any investor in such is trade is always related to tax.