How short selling works

The majority of investors invest in common stocks so that after buying them they can sell them. Being the direct possessor of stocks is denominated as long position. The opposite would be a short position which is based on the expectation that the stock price will drop. A short position indicates that a value has been borrowed and later sold without being replaced.

When stock prices tend to raise you may benefit from buying them. Or, opposite, you may benefit from selling short stocks before the prices lowers. In a short sale you borrow stocks to sell them with the hope price will decrease. If it does not you may buy them back at a lower price and give them back to the one who lend them.

This procedure example is illustrated next.

Ms. X thinks that Schering Plough, Ticker Symbol SGP (the pharmaceutical company)  stocks are overvalued and that they will drop. She allocates her order with her broker to sell 100 SGP stocks short that are being negotiated at $43 per stock (total price is $4,300 not including commissions). The brokerage firm has 3 week days of negotiation to give the 100 SGP stocks to the buyer and has various sources from where to borrow these stocks. It could borrow them from its own SGP stocks  inventory, if he had any, or from other brokerage firm. The most probable is that they borrow stocks in custody from their street name stocks in their margin accounts. In this example the brokerage firm finds the 100 SGP stocks in a margin account that belongs to Mr. Y. The brokerage firm sends these stocks to the buyer in sold short of these by Ms X, and notifies SGP about the new owners.

Al parts of this transaction are satisfied. The buyer bought the stocks. The short seller, Ms. X, has its $4,300 not including commissions. Kept in a margin account and the brokerage firm has received their corresponding commissions. The $4,300 (minus commissions) are kept under custody in the firms margin account (they cannot withdrawn by Ms. X) as protection in case of a breach of contract occurs in Ms. X short sale. Mr. Y who more likely has signed the loan approval in opening its margin account is indifferent  towards the process. He still keeps all his rights over the 100 SGP stocks.

When the said stocks generate dividends who gets them? Before the short sale the brokerage firm would have received the corresponding dividends from the 100 SGP stocks kept under a street name in Mr. Y?s margin account , and this amount would have been deposited in its margin account. Nevertheless, these stocks have been used in short sale and have been given to the new buyer who will get dividends from Schering Plough. Mr. Y still has the right to get the dividends.

The short seller, Ms. X, who got the stocks as loan, must pay Mr. Y an equal amount as those of dividends through the brokerage firm.

When SGP stocks drop to an $19 price per stock Ms. X allocates a buying order to cover the short position. Stocks are sent back to the brokerage firm and Ms. X has earned a profit of $25 per stock, without counting with the paid commission rates during transactions and from dividends returned to Mr. Y.

As said at the beginning short sales are done through margin accounts. There is always a possibility that Ms. X left the city and then the brokerage firm would be 100 SGP stocks short. By using a margin account the short seller (Ms. X) has to deposit in her account the received incomes due to short sale, and also has to pay an additional amount of money. This is the margin requirement previously discussed.

Margin accounts provide a larger leverage than those of cash accounts. Ms. X paid $2,125 and received a return of 111% (2,358 / 2,125).

Cash transactions require that the total stock investment be supported by cash which reduces the return rate.

Leverage is the creation of a loss or win, proportionally larger than an underlying investment by using money from other people. The use of leverage has a double edge sword effect. In case of loss the loss percentage is higher in margin trading than in a cash trade.