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Ariel Courage is an experienced editor, researcher, and former fact-checker. She has performed editing and fact-checking work for several leading finance publications, including The Motley Fool and Passport to Wall Street.
In finance, the margin is the collateral that an investor has to deposit with their broker or exchange to cover the credit risk the holder poses for the broker or the exchange. For example, a short position cannot be established without sufficient margin.
In the case of short sales, under Regulation T, the Federal Reserve Board requires all short sale accounts to have 150% of the value of the short sale at the time the sale is initiated. The 150% consists of the full value of the short sale proceeds (100%), plus an additional margin requirement of 50% of the value of the short sale.
Short selling occurs when a trader borrows a security and sells it on the open market, planning to buy it back later for less money. Theoretically, the price of an asset has no upper bound and can climb to infinity. This means that, in theory, the risk of loss on a short position is unlimited.
Short positions represent borrowed shares that have been sold in anticipation of buying them back in the future. As the underlying asset prices rise, investors are faced with losses to their short position. Aside from the pressure of mounting paper losses, maintaining a short position can also become more difficult because, if the price of the underlying asset rises, so does the amount of margin required as collateral to ensure that the investor will be able to buy back the shares and return them to the broker.
When investors are forced to buy back shares to cover their position, it is referred to as a short squeeze. If enough short sellers are forced to buy back shares at the same time, then it can result in a surge in demand for shares and therefore an extremely sharp rise in the underlying asset's price.
In finance, being short in an asset means investing in such a way that the investor will profit if the market value of the asset falls. This is the opposite of the more common long position, where the investor will profit if the market value of the asset rises. An investor that sells an asset short is, as to that asset, a short seller.
There are a number of ways of achieving a short position. The most basic is physical selling short or short-selling, by which the short seller borrows an asset (often a security such as a share of stock or a bond) and quickly selling it. The short seller must later buy the same amount of the asset to return it to the lender. If the market value of the asset has fallen in the meantime, the short seller will have made a profit equal to the difference. Conversely, if the price has risen then the short seller will bear a loss. The short seller usually must pay handling fee to borrow the asset (charged at a particular rate over time, similar to an interest payment) and reimburse the lender for any cash return (such as a dividend) that was paid on the asset while borrowed.
A short position can also be created through a futures contract, forward contract, or option contract, by which the short seller assumes an obligation or right to sell an asset at a future date at a price stated in the contract. If the price of the asset falls below the contract price, the short seller can buy it at the lower market value and immediately sell it at the higher price specified in the contract. A short position can also be achieved through certain types of swap, such as a contract for difference. This is an agreements between two parties to pay each other the difference if the price of an asset rises or falls, under which the party that will benefit if the price falls will have a short position.
Because a short seller can incur a liability to the lender if the price rises, and because a short sale is normally done through a stockbroker, a short seller is typically required to post margin to its broker as collateral to ensure that any such liabilities can be met, and to post additional margin if losses begin to accrue. For analogous reasons, short positions in derivatives also usually involve the posting of margin with the counterparty. Any failure to post margin promptly would prompt the broker or counterparty to close the position.
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. Alternatively, traders or fund managers may use offsetting short positions to hedge certain risks that exist in a long position or a portfolio.
Research indicates that banning short selling is ineffective and has negative effects on markets.[1][2][3][4][5] Nevertheless, short selling is subject to criticism and periodically faces hostility from society and policymakers.[6]
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 the same number of equivalent securities and returns them to the lender. The act of buying back the securities that were sold short is called covering the short, covering the position or simply covering. 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, for it already holds the securities that it will return to the lender.
The process relies on the fact that the securities (or the other assets being sold short) are fungible. An investor therefore "borrows" securities in the same sense as one borrows a $10 bill, where the legal ownership of the money is transferred to the borrower and it can be freely disposed of, and different bank notes or coins can be returned to the lender. This can be contrasted with the sense in which one borrows a bicycle, where the ownership of the bicycle does not change and the same bicycle must be returned, not merely one that is the same model.
"Shorting" or "going short" (and sometimes also "short selling") also refer more broadly to any transaction used by an investor to profit from the decline in price of a borrowed asset or financial instrument. Derivatives contracts that can be used in this way include futures, options, and swaps.[7][8] These contracts are typically cash-settled, meaning that no buying or selling of the asset in question is actually involved in the contract, although typically one side of the contract will be a broker that will effect a back-to-back sale of the asset in question in order to hedge their position.
The practice of short selling was likely invented in 1609 by Dutch businessman Isaac Le Maire, a sizeable shareholder of the Dutch East India Company (Vereenigde Oostindische Compagnie or VOC in Dutch).[9] Short selling can exert downward pressure on the underlying stock, driving down the price of shares of that security. This, combined with the seemingly complex and hard-to-follow tactics of the practice, has made short selling a historical target for criticism.[10] At various times in history, governments have restricted or banned short selling.
The London banking house of Neal, James, Fordyce and Down collapsed in June 1772, 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. In another well-referenced example, George Soros became notorious for "breaking the Bank of England" on Black Wednesday of 1992, when he sold short more than $10 billion worth of pounds sterling.
The term short was in use from at least the mid-nineteenth century. It is commonly understood that the word "short" (i.e. 'lacking') is used because the short seller is in a deficit position with his brokerage house. Jacob Little, known as The Great Bear of Wall Street, began shorting stocks in the United States in 1822.[11]
Short sellers were blamed for the Wall Street Crash of 1929.[12] Regulations governing short selling were implemented in the United States in 1929 and in 1940.[13] Political fallout from the 1929 crash led Congress to enact a law banning short sellers from selling shares during a downtick; this was known as the uptick rule and was in effect until 3 July 2007, when it was removed by the Securities and Exchange Commission (SEC Release No. 34-55970).[14] President Herbert Hoover condemned short sellers and even J. Edgar Hoover said he would investigate short sellers for their role in prolonging the Depression.[citation needed] A few years later, in 1949, Alfred Winslow Jones founded a fund (that was unregulated) that bought stocks while selling other stocks short, hence hedging some of the market risk, and the hedge fund was born.[15]
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; short-sellers were forced to cover their positions at acquisition prices, while in many cases the firm often overpaid for the start-up.[citation needed]
Temporary short-selling bans were also introduced in the United Kingdom, Germany, France, Italy and other European countries in 2008 to minimal effect.[19] Australia moved to ban naked short selling entirely in September 2008.[16] Germany placed a ban on naked short selling of certain euro zone securities in 2010.[20] Spain, Portugal and Italy introduced short selling bans in 2011 and again in 2012.[21]
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