Short Selling - Questions

[patriots101]

I have a lot of questions about this......so i'll just go ahead and list them all :D

1. What exactly does it mean to short a stock?

2. Why is it profitable to short sell when a stock price is going down? Where does the monetary gain you achieve from this action come from?

3. Is it possible to short any stock I want?

4. Is there limited upside and unlimited downside?

5. Is short selling anyway related to stock options? And more specifically buying puts?

I often read on message boards how the shorts are bringing down the price of a stock. Is this possible? If so, how does this happen?

Thx in advance :D

[aiki14]

I have a lot of questions about this......so i'll just go ahead and list them all :D

1. What exactly does it mean to short a stock?

2. Why is it profitable to short sell when a stock price is going down? Where does the monetary gain you achieve from this action come from?

3. Is it possible to short any stock I want?

4. Is there limited upside and unlimited downside?

5. Is short selling anyway related to stock options? And more specifically buying puts?

I often read on message boards how the shorts are bringing down the price of a stock. Is this possible? If so, how does this happen?

Thx in advance :D

1) Shorting is borrowing a bunch of shares and paying back the shares at a later date.

2) You borrow 100 shares at 10$/share worth $1000 the price goes down to $9/share and you pay back the shares and pocket the $100

3)No, some are not available due to demand, and some are not shortable due to SEC regulations.

4) Upside is limited to the difference between your price and zero, downside is theoretically unlimited.

5) No, except in the sense that you profit from down moves in both cases.

The way shorts bring down prices is somewhat complicated, but is related to overselling the stock. It would require a fair amount of space to really explain this.

[Svenwulf]

extra points to aiki's fine response. i am sorry if its gibberish.

short sellers get more credit then they deserve. when you hear "the shorts are manipulating the price down" often i find the true case is a broken stock, or a broken company; an unsound investment. make no mistake that manipulation of price is a daily event. but the vast majority of any market bias is always to the upside. to be consistently profitable against a trend (a short seller) takes an extra amount of skill/ risk. it would follow the "pool" of these rarer individuals would be proportionately smaller. and the capital available to these players would also be smaller. add the difficulty mentioned in securing shares to borrow, and you can see how difficult it theoretically should be for shorts to keep the price down. as always, it becomes a case by case analysis, but when you see a half million shares hit the bid of a stock your in, its at best unlikely to be "the shorts manipulating the price down." best wishes.

[Bman409]

Shorts can artificially bring down the price of a stock by BORROWING shares they do not own, and selling them

Of course this is simply "selling on margin", the opposite of "buying on margin"

In both cases, the trader is borrowing (money in one case, stock in the other) and making a bet on it

[netwrangler]

Q. Is there limited upside and unlimited downside [to short sales]?

A. Upside is limited to the difference between your price and zero, downside is theoretically unlimited.


First, please note that the "quote" above is actually a composite of Question #4 from the thread starter and Aiki's answer.

My question to Aiki, et alia is:
If you believe the price of a stock will decline, what are the relative merits of shorting the stock as opposed to buying puts on the stock?

I can see several mechanical differences, but it's hard for me to evaluate them.

BTW: If you respond, "What differences do you see?" I'll take that as an assignment and report back. On the other hand, after reading your posts, you might be able to nail this in 25 words or less.

TIA

[aiki14]

First, please note that the "quote" above is actually a composite of Question #4 from the thread starter and Aiki's answer.

My question to Aiki, et alia is:
If you believe the price of a stock will decline, what are the relative merits of shorting the stock as opposed to buying puts on the stock?

I can see several mechanical differences, but it's hard for me to evaluate them.

BTW: If you respond, "What differences do you see?" I'll take that as an assignment and report back. On the other hand, after reading your posts, you might be able to nail this in 25 words or less.

TIA

One diff is not all stocks have associated options, but for the sake of your question let's assume a stock that does.
Due to leverage the put's will react to a move in the stock price with a larger move in their price on a percentage basis. If the stock price rises 1% the put may lose 5 or 10%, and a 10% move up may result in a total loss on the puts. Additionally there is no expiry on the short position so you don't have time value concerns.
This particular scenario is difficult to calculate on a risk/reward basis since there is limited risk on the short, time value on the puts, and the lack of delta (the amount of price change of the option compared to the stock) on in the money puts.
In general (9 times out of 10) I will take a short stock position rather than straight puts. I use put's mainly to protect long stock positions, or in straddles. If however you can get a good value on way out of the money puts then you can get a ton of delta if the stock tanks. If you have a good idea that will happen you will get paid off in the puts.
More than 25 words, I hope helpful.

[netwrangler]

In general (9 times out of 10) I will take a short stock position rather than straight puts. I use put's mainly to protect long stock positions, or in straddles. If however you can get a good value on way out of the money puts then you can get a ton of delta if the stock tanks. If you have a good idea that will happen you will get paid off in the puts.
More than 25 words, I hope helpful.
Succinct and to the point!

I'm tempted to take Aiki's response as a head start and develop a decision matrix based on it. I say "tempted" because, as a former planner, I'm much better at thinking up work that could be done than I am at actually doing it. Well, let's see how the time goes over the next week or so.

[theticktrader]

Good post.. OP, just remember, this is a ZERO SUM game! If you buy something, someone had to sell it to you.. .If you gain $10K, somewhere, 10K is lost...

[netwrangler]

Good post.. OP, just remember, this is a ZERO SUM game! If you buy something, someone had to sell it to you.. .If you gain $10K, somewhere, 10K is lost...This 'zero sum' game morphs when you introduce the concept of hedging.

A natural gas producer may hedge with a 'costless collar' on the product — selling a 'call' to set a max price while buying a 'put' to ensure a minimum price. For the natural gas producer, the collar itself was a win. It is totally irrelevant that someone may make (or lose) money on the call or put.

Note: There is a time factor that applies here. The hedger is concerned with assuring a profit at some date in the future. The put and call traders have their own game going, and that might, indeed, be zero-sum.

Similarly, this is how covered call investors work in the options market. For the covered call investor, the underlying security is the "commodity" they are hedging.
Do they "win" the [zero-sum] game by selling the calls?

That's the wrong question. They are hedging their long position on the [stock/commodity].
Depending on investment objectives, an 'assured' profit may be preferred to a 'max' profit.

[Svenwulf]

looks like i missed some fun here, thanks for digging this up net.

bman- shorts can not artificially bring down the price of a stock. strategic ftds are a seperate case, but really the downward manipulation of a stock price is generated on the buy side. or more simply, if an excessive supply of a security is offered at less then the "current market range" too many market participants will find the easy profit, eliminating any advantage sought.

ticktrader- a zero sum game applies only to futures and options. i would argue those to be less then zero sum games considering commisions and fees. a decent, simple explination found in myth #1
http://www.investopedia.com/articles/02/061902.asp

[netwrangler]

One diff is not all stocks have associated options, but
for the sake of your question let's assume a stock that does.
Due to leverage the put's will react to a move in the stock price with a larger move in their price on a percentage basis. If the stock price rises 1% the put may lose 5 or 10%, and a 10% move up may result in a total loss on the puts. Additionally there is no expiry on the short position so you don't have time value concerns.
This particular scenario is difficult to calculate on a risk/reward basis since there is limited risk on the short, time value on the puts, and the lack of delta (the amount of price change of the option compared to the stock) on in the money puts.
In general (9 times out of 10) I will take a short stock position rather than straight puts. I use put's mainly to protect long stock positions, or in straddles. If however you can get a good value on way out of the money puts then you can get a ton of delta if the stock tanks. If you have a good idea that will happen you will get paid off in the puts.
More than 25 words, I hope helpful.

Succinct and to the point!

I'm tempted to take Aiki's response as a head start and develop a decision matrix based on it. I say "tempted" because, as a former planner, I'm much better at thinking up work that could be done than I am at actually doing it. Well, let's see how the time goes over the next week or so.I remain 'tempted' here — to the point of actually working up some figures.

In my view short sales [or at least trades based on a belief that a stock will decline] are going to be more important in 2008 than they were this year. So, here is what I understand about the rules of short selling:

Federal Reserve Board Regulation "T" pertains in this area;
Under Reg-T, a short seller must have a margin account with assets equal to 100% of the 'sale' plus 50%;
As the price of a short-sale stock goes up, the margin requirements for maintaining the short position are 100% of the short sale plus 25%;
Using those rates, the actual margin requirement dollar value would not change until the stock price increased by 20%;
At all times, the short-sale stock shares are 'borrowed' and subject to interest payments on the loan.
It is not clear to me how these 'loan' interest charges are assessed. My guess would be they would be assessed daily and tied to the closing price of the stock from the previous day.

My goal here is to come up with a quantitative analysis of the difference between short sales and buying puts. To all members, I would truly appreciate any factual additions and/or constructive criticisms you may wish to contribute to this post.

A special note regarding Aiki's post: I challenged Aiki to analyze short sales versus puts "in 25 words or less." He came back with a really good, and concisely stated, 'take' on the question. I'm not sure exactly what my 'detailed' analysis will show, but I will bet you that Aiki's response remains right on in direction.

[TonyM]

Iirc only interest on the amount of short position held above the cash balance in your account. You do however have to pay any dividend that occurs while holding the position.

The maintenance requirement is likely determined by each broker differently, 100% seems unlikely though, most stocks require 35% for example, with Scottrade.

[TonyM]

After going back and looking I see that I misunderstood your maintenance requirement statement. Anything above the initial 150% margin requirement would result in a margin call assuming that was the maximum account value at the time. Do some brokers give less margin than your collateral?