A short sale is any sale of a security which the seller either does not own, or owns but chooses not to deliver the security.
Thus, a short sale is any sale which is consummated by the delivery of a borrowed security by, or for the account of, the seller. To make delivery in such a transaction, the broker loans the investor the stock. Because the customer usually does not own the stock, he or she must buy the stock at some future date to meet the sales commitment, i.e. “cover the short position.”
People who sell stock short expect the value of a security to decline. In short, short selling is a way of making money if a stock goes down. If the stock appreciates in value, the short-seller loses the difference between the amount paid when he or she eventually buys the shares and the amount he or she received when originally sold. Alternately; if the security declines in value, the strategy is profitable as the customer can buy back for less than the selling price.
At this time, Regulation T (the Federal Reserve Board’s margin regulation) on short sales is 50 percent. Thus, a customer selling short 100 shares of XYZ at $50 a share would be required to deposit $2,500 into his or her account. Notice that by selling short the customer is effectively creating additional shares of XYZ in the marketplace. The required deposit mitigates the effect of this new wealth in the economy. Additionally, this deposit acts as security for the broker, since the customer does not actually have the stock that has been sold. In cases where the investor already owns the stock, they must keep at least 50 percent of what they sold short in the account.
For example, an investor sells short 100 shares of XYZ at $50. His or her account has $5,000 added to it from the short sale. Subsequently, the price of XYZ falls to $40. The investor buys back the XYZ shares at $40. His or her account is debited $4000. Thus the investor realizes a profit of $1,000 ($5,000 – $4,000 = $1,000) less transaction costs. Of course, if XYZ has risen to $75 instead, and the investor, afraid of even further rises, bought it back at that point, he or she would realize a loss of $2,500 ($5,000 – $7,500 = $-2,500) plus transaction costs.
Quote of the week: “A man is not finished when he is defeated. He is finished when he quits.” — Richard M. Nixon
Bart Ward is the chief executive officer of Ward & Co. Ltd., an Anoka-based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.