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Short Selling – Summary

  • Short-selling is the practice of selling securities the seller does not own, in the hope of repurchasing them later at a lower price.
  • This is done with the intention to profit from an expected decline in price of a security, as opposed to the ordinary investment practice in which an investor buys or goes long in a security in the hope that the price will rise subsequently.
  • In order to profit from the stock price going down, investors can borrow a security and sell it, with the expectation that the price will decrease so that they can buy it back at a lower price and keep the difference.
  • The short-seller is obliged to deliver the shares to his broker, who usually in turn would have borrowed the shares from some other investor who is in actual possession of the said shares.
  • In most countries the regulatory requirements are such that if an investor goes short in a cash market, the investor should arrange to borrow the security and deliver the same as if he has sold a security that was in his possession.
  • When the seller does not borrow or arrange to borrow the securities in time to make delivery to the buyer with the standard three-day settlement period, the short sale is known as naked short sale. The buyer of such shares seldom receives the shares, and the situation is technically described as failure to deliver.
  • The short-selling process involves several steps, starting with borrowing the shares, selling short, buying to cover, and thus closing out the position.
  • Short-selling is fraught with several risks and is quite dangerous as an investment strategy, as the investor can get into a short squeeze caused either by market forces or deliberately by any group of market players to corner the investor.
  • Hedge funds often resort to short-selling shares in which they already hold long positions, which is also known as a box position. Strictly, box positions do not alter the profits or profitability for the investor except that the accounting for the same gets a little complicated.
  • However, for tax purposes, box position short sales are treated as if the original long position is liquidated.
  • In spite of the severe criticism of short-selling, it is not without any merits, especially as it is an essential part of the price discovery mechanism. Several leading investors have hailed short-selling as a useful counterweight to the widespread bullishness in the market, and some believe that short-sellers are useful in uncovering fraudulent accounting and other problems at companies.
  • There are several regulatory requirements regarding short sales in different countries, depending upon the current status of the economy. By and large there exist certain fundamental regulations regarding the requirements for short sales, which should be adhered to by the market players.
  • Securities lending or stock lending refers to the lending of securities by one party to another. The terms of the loan are governed by a securities lending agreement, which normally requires that the borrower provide the lender with collateral, which could be in the form of either cash or government securities of value equal to or greater than the loaned securities.
  • Towards the charges for the loan, both the parties negotiate a fee, quoted as an annualized percentage of the value of the loaned securities.
  • If the collateral provided by the borrower is cash, then the fee is quoted as a rebate. This means that the lender will earn interest on the cash collateral provided by him, and will adjust this as a rebate from the agreed rate of interest to the borrower.
  • Securities lending is legal and regulated in most of the world’s major securities markets. Most markets mandate that the borrowing of securities be conducted only for specifically permitted purposes.
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