Selling Short

[EightCounts]

Can someone please explain this excerpt from Cramer's book, Confessions of a Street Addict? I am not able to grasp the concept of selling short. So dumbing it down for me would be awesome.

But we were sloppy about our comeback. That was the summer a clerk on the trading desk made the $40,000-in-a-nanosecond error, my worst ever, because he didn't listen to a simple instruction I had given to cover a short in Philip Morris, forcing me to pay the dividend that normally the company owes. (The short seller is just borrowing the stock from someone else to sell it short, and the short seller has to pay that dividend to that someone else unless he covers his position first, that is, buys back the stock, which you should always do, and which I had explicitly said to do.)

[Albert0373]

Short Selling: What Is Short Selling?



The Basics
When an investor goes long on an investment, it means she has bought a stock believing its price will rise in the future. Conversely, when an investor goes short, he is anticipating a decrease in share price.

Short selling is the selling of a stock that the seller doesn't own. More specifically, a short sale is the sale of a security that isn't owned by the seller, but that is promised to be delivered. That may sound confusing, but it's actually a simple concept.

Still with us? Here's the skinny: when you short sell a stock, your broker will lend it to you. The stock will come from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. The shares are sold and the proceeds are credited to your account. Sooner or later you must "close" the short by buying back the same number of shares (called covering) and returning them to your broker. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money.

Most of the time, you can hold a short for as long as you want. However, you can be forced to cover if the lender wants back the stock you borrowed. Brokerages can't sell what they don't have, and so yours will either have to come up with new shares to borrow, or you'll have to cover. This is known as being called away. It doesn't happen often, but is possible if many investors are selling a particular security short.

Since you don't own the stock (you borrowed and then sold it), you must pay the lender of the stock any dividends or rights declared during the course of the loan. If the stock splits during the course of your short, you'll owe twice the number of shares at half the price.

Also, because you are being loaned the stock, you are buying on margin. In fact, you have to open a margin account to short stocks.

Why Short?
There are two main motivations to short:

1. To speculate
The most obvious reason to short is to profit from an overpriced stock or market. Probably the most famous example of this was when George Soros "broke the Bank of England" in 1992. He risked $10 billion that the British pound would fall and he was right. The following night, Soros made $1 billion from the trade. His profit eventually reached almost $2 billion.

2. To hedge
For reasons we'll discuss later, very few sophisticated money managers short as an active investing strategy (unlike Soros). The majority of investors use shorts to hedge. This means they are protecting other long positions with offsetting short positions.


Restrictions
There are many restrictions on the size, price and types of stocks you are able to short sell. For example, you can't short sell penny stocks and most short sales need to be done in round lots.

In addition, the SEC, NYSE and NASD have rules preventing short selling unless the last trade of the stock is at the same or higher price (known as an uptick or zero plus tick). These rules exist so that investors can't sell short in a declining market. Continuous short selling on a falling stock will keep forcing it down, damaging the market further.

Source: Investopedia.com

[EightCounts]

Thanks for the info, I'll be using that site frequently. But one question: How does the person/company that loans the stock benefit?

[AJLightning]

Love the KNOWLEDGE...

thanks AL

[AJLightning]

Originally Posted by EightCounts

Thanks for the info, I'll be using that site frequently. But one question: How does the person/company that loans the stock benefit?

the loaner or broker will hold that "short stock" at that price...when it goes up, they will sell it higher to us, but at the low price it was shorted at???

make sense...just a guess

[aiki14]

The broker will sell options positions against the short to hedge the position. Loan the short seller 100 shares and buy a put and sell a call. If the price drops the put covers the down side, if it goes up the borrower pays the broker the upside. The call premium covers the price of the put. Add in the various commissions and the broker makes money regardless.

[concrete]

Originally Posted by aiki14

Add in the various commissions and the broker makes money regardless.

Aiki:

When you put it that way, isn't calling him/her a broker, a misnomer; maybe bookie with be a more apt sobriquet?

[aiki14]

Originally Posted by concretist

Aiki:

When you put it that way, isn't calling him/her a broker, a misnomer; maybe bookie with be a more apt sobriquet?

A rose by any other name still gets the vig. The retail side of the house makes money off trading clients money.

[aiki14]

Originally Posted by concretist

Aiki:

When you put it that way, isn't calling him/her a broker, a misnomer; maybe bookie with be a more apt sobriquet?

A rose by any other name still gets the vig. The retail side of the house makes money off trading clients money.

[Mustard182]

As an account holder, is there anyway that you can make sure your shares are not shorted? This would matter more for stocks with a very high short ratio.