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Selling Long and Selling Short

Selling Long and Selling Short

SHORT SELLING IN THE UNITED STATES

THE BENEFITS AND HISTORY OF SHORT SELLING

BIBLIOGRAPHY

In the field of finance selling long (or going long) on a security or an investment means that an investor buys that security or investment with the prospect of keeping it for some time because he or she believes that its price (or value) is going to increase in the long run. This investment action is called a long position in that particular security or investment.

The opposite practice is known as selling short or short selling a security or an investment. An investor who gets involved in short selling believes that the price of the underlying security is going to decrease in the near future. Hence, that investor borrows shares of the security he or she anticipates will have a price decrease and then sells those shares at the current market price, expecting to pay back the loan in stocks when the price of the security drops. This way the investor makes a profit by selling high and buying low, but he or she sells first and buys later. Thus, because the investor does not own the underlying security but only borrows and sells it, it is considered that that investor is in a short position regarding that particular security. Of course, a high risk is involved in such investment actions because the price of the security or investment in which someone has a short position could rise instead of fall, and then the investor has to pay more and loses money instead of gaining as he or she anticipated.

In general, an investor will go long or have a long position in a security or an investment when that investor expects the price to rise and will have a short position when he or she expects the price to drop. However, short selling is not allowed in all countries. The term short is used because it indicates an inadequacy, and in finance it is applied to situations in which investors sell securities that they do not own. Therefore, such a sale is called short sale because it creates an inadequacy, a negative position, in the sold security. In a portfolio the percentage that shows the portion of the security that is in a short position is negative. The securities in which a long position is held have positive percentages in portfolio weights. The sum of the portion of each security that makes up a portfolio is always equal to one despite any long or short positions in the participating securities.

SHORT SELLING IN THE UNITED STATES

In the United States the process of short selling proceeds as follows:

  1. An investor interested in short selling borrows shares of a security from a brokerage firm. However, in the United States there is a rule that the investor has to deposit cash in his or her brokerage firm amounting to 50 percent of the value of the borrowed shares (this is called a margin).
  2. The investor then sells the borrowed shares and credits the proceeds from the sale at his or her cash account in the brokerage firm.
  3. At a specified time agreed on with the brokerage firm the investor must close the position by buying back the shares from the market.
  4. The investor must return the shares to the broker (lender) as was agreed. If the price of the underlying shares increases, the investor suffers a loss. If that price decreases as expected, the investor makes a profit.

Furthermore, by law since 2005 regulated brokerdealers in the United States do not allow their customers to short sell securities if the customers have not arranged for a broker-dealer to confirm that the brokerage firm is able to deliver the underlying securities. This process is called locating. The brokerage firms can borrow shares in many ways, facilitating locates and delivering the short-selling securities. U.S. brokers can borrow stocks from leading custody banks such as JP Morgan Chase (New York), Citibank (New York), Mellon Bank Corp. (Pittsburgh), the Bank of New York (New York), the Northern Trust Company (Chicago), State Street Corporation (Boston), Robeco (Netherlands), UBS (Zurich), fund management companies, and even their customers who have long positions in those stocks.

In the United States, to avoid a high amount of loss, short sellers can place a stop loss order with the brokerage firm after selling a stock short. Then the broker has to cover the position if the price of the underlying stock increases to a certain level, limiting the loss to the customer.

A short-selling investor has to pay a fee at the brokerage company that facilitates that investors short-selling activities. Usually this is a standard commission fee, as with buying a security.

If the price of the shares in a short position rises instead of falling, the broker will deduct money from the investors cash account and transfer it to the investors margin account. If the price continues to increase and there are not enough funds in the investors cash account to cover the investors position, the investor will have to borrow on margin and will begin to accrue margin interest charges. Furthermore, if the stock on a short position pays dividends and the dividend date passes while the investor is short on the stock, the dividend will be deducted from the investors account.

THE BENEFITS AND HISTORY OF SHORT SELLING

According to Jones and Lamont (2001), short selling makes an important contribution to the efficiency of the stock market. There are limits to arbitrage. Specifically, some stocks can become overpriced. A group of investors may realize this and adopt a short position in those overpriced stocks. When the stocks are sold in the market, their prices are driven downward (high supply, low prices), and eventually they reach an equilibrium price level.

Historically, short-selling practices were reported in the seventeenth century during the scandal that arose after the violent fall of the Dutch tulip market. In the eighteenth century England banned short selling. In the nineteenth century the term short was used in the United States. In the early twentieth century the short-selling activities of traders were blamed for the Wall Street crash of 1929. After that time severe regulations on short selling were implemented in 1929, 1938, and 1940. Legislated rules that banned mutual funds from engaging in such activities were lifted in 1997. In 2005 the Securities and Exchange Commission established locate and close-out requirements for brokerage firms.

SEE ALSO Arbitrage and Arbitrageurs; Banking; Efficient Market Hypothesis; Financial Instability Hypothesis; Financial Markets; Great Depression; Great Tulip Mania, The; Interest Rates; Interest, Own Rate of; Returns; Speculation; Spot Market; Stock Exchanges

BIBLIOGRAPHY

Aitken, Michael J., Alex Frino, Michael S. McCorry, and Peter L. Swan. 1998. Short Sales Are Almost Instantaneously Bad News: Evidence from the Australian Stock Exchange. Journal of Finance 53: 22052223.

DAvolio, Gene. 2001. The Market for Borrowing Stock. Harvard University Working Paper. Boston, MA: Harvard University, Graduate School of Business Administration.

Dechow, Patricia M., Amy P. Hutton, Lisa Meulbroek, and Richard G. Sloan. 2001. Short-Sellers, Fundamental Analysis and Stock Returns. Journal of Financial Economics 32: 125158.

Diamond, Douglas W., and Robert E. Verrecchia. 1987. Constraints on Short-Selling and Asset Price Adjustment to Private Information. Journal of Financial Economics 18: 227311.

Fabozzi, Frank J. 2004. Short Selling: Strategies, Risks, and Rewards. Hoboken, NJ: Wiley.

Jones, C. M., and O. A. Lamont. 2001. Short Sale Constraints and Stock Returns. Journal of Financial Economics 67: 207239.

Whitney, Richard, and William R. Perkins. 1932. Short Selling. New York and London: D. Appleton.

Katerina Lyroudi

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