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FINANCIAL SECURITIES: SHORT SELLING

FINANCIAL SECURITIES: SHORT SELLING. CIE 3M1. AGENDA. SHORT SELLING: A DEFINITION SHORT SELLING: THE PROCESS SHORT SELLING, LIABILITY AND MARGINS SHORT SELLING IN DETAIL SHORT SELLING: POTENTIAL DIFFICULTIES. SHORT SALES: AN INTRO.

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FINANCIAL SECURITIES: SHORT SELLING

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  1. FINANCIAL SECURITIES: SHORT SELLING CIE 3M1

  2. AGENDA • SHORT SELLING: A DEFINITION • SHORT SELLING: THE PROCESS • SHORT SELLING, LIABILITY AND MARGINS • SHORT SELLING IN DETAIL • SHORT SELLING: POTENTIAL DIFFICULTIES

  3. SHORT SALES: AN INTRO • Usually investors buy and own securities because they believe the price will likely rise in the future. This results in the investor being LONG in the security. Why do you think they call it being “long”? • But what if an investor believes the price of a security will decline? Wouldn’t it be wise to sell and his/her cut losses? • But what if the security is not owned? A profit can still be made from a decline in the price. How!? By selling a security SHORT of course!

  4. SHORT SALES: A DEFINITION • The sale of a stock NOT OWNED by the investor but BORROWED from a third party in order to take advantage of an expected decline in the price of the stock.

  5. SHORT SALES: THE PROCESS • Assume that Jane wants to SHORT SELL stock XYZ but he doesn’t own any. Then how does Jane short sell something he does not own? Here’s how. • Presently XYZ is trading at $10 per share but Jane expects it to decline to $5 by the end of the week.

  6. SHORT SALES: THE PROCESS • Step 1: Jane borrows stocks of XYZ from a third party, Joe – a broker will arrange the borrowing of the securities from others who have them in margin accounts and lend them to the short seller.

  7. SHORT SALES: THE PROCESS • Step 2: Jane’s broker sells the borrowed securities in the open market like any other sale. Assume the broker managed to sell XYZ for $10 per share.

  8. SHORT SALES: THE PROCESS • Step 3: Assume XYZ declines to $5 per share at the end of the month. Jane would then instruct the broker to repurchase the stock at the currently lower price and cancel the SHORT POSITION (i.e. by replacing the borrowed stock from Joe).

  9. SHORT SALES: THE PROCESS • Step 4: Jane profits equal the difference between the price at which the borrowed stock was sold and the price at which it was repurchased.

  10. SELLING SHORT: AN EXAMPLE • Jeff thinks that the price of WOW shares are going to fall in the next two months and wants to turn a profit based on this belief even though he does not own any WOW. Jeff calls his broker and tells him to sell 1000 shares of WOW short at its current price of $20 per share. The broker borrows 1000 shares of WOW from Amy who has an account with the brokerage firm and currently owns WOW “long”. The broker sells the 1000 shares of WOW at the current price of $20 per share crediting the $20,000 proceeds into Jeff’s account.

  11. SELLING SHORT: AN EXAMPLE • Two months pass and the price of WOW declines to $15 per share. Jeff is satisfied so he tells his broker to buy 1000 shares of WOW and close out the short position. His profit is therefore $20,000 minus $15,000 = $5,000 (ignoring commissions). The broker replaces Amy’s missing stock with the just purchased shares of WOW which was bought at the declined price. The transaction is complete!

  12. SELLING SHORT: KEEP IN MIND! • A short seller must be approved for a margin account because he/she is liable for “borrowing” securities from another investor and is therefore subject to a margin call. • Remember: short selling is defined as the sale of securities that the seller does not own! • The investor is said to be in a short position since he/she must repay it in the future; hopefully it can be repurchased at a lower price so he/she can make a profit!

  13. SELLING SHORT: KEEP IN MIND! • The investor must leave the proceeds of the short sale as well as a certain portion of the market value in addition to the proceeds with the dealer. • Basically, the investor must put up more funds to show that she/he is good for repurchasing the “borrowed” stocks in the future, even if their market price ends up increasing.

  14. SELLING SHORT: KEEP IN MIND!

  15. DETAILS OF SHORT SELLING • Short Sellers are responsible for paying dividends declared on borrowed stocks to the person who “lent” them to the short seller. Dividends declared on any stock sold short must be covered by the short seller because the person from whom he/she borrowed it from technically still owns the stock and expects dividends paid on it. • Short sellers must have a margin account to sell short and must put up margin as if they had gone “long”. The margin can consist of cash or any restricted securities held long

  16. DETAILS OF SHORT SELLING • There is no time limit on a short sale. The only protection arises when the lender wants the stock back but in most cases, brokers can borrow them from someone else. • Short sales are permitted only on rising prices or an uptick. A short seller can sell short at the last trade price only if that price exceeded the last different price before it (i.e. going up).

  17. DETAILS OF SHORT SELLING • The net proceeds from a short sale, plus the required margin, are held by the broker; thus, no funds are immediately received by the short seller. The lender is fully protected, i.e. if the price of the stock rises, the short seller will have to put up more funds to satisfy the margin requirement or repurchase the borrowed stock for the lender.

  18. SELLING SHORT: AN EXAMPLE • Suppose stock WOW is eligible for special margin (i.e. requires a margin of 130%). When Jeff short sells the 1000 shares of WOW for $20 each, the sale proceeds of $20,000 will remain in an account with his brokerage firm. Since $20,000 represents 100% of his liability at the time, Jeff must also deposit an additional $6,000 ($20,000 times 30%) with the firm to satisfy the 130% margin requirement. Thus Jeff’s total cost for making his short sell is $26,000.

  19. SELLING SHORT: AN EXAMPLE • If Jeff ends up being wrong and the price of WOW increases to $25 per share, his liability increases to $25,000 (1000 shares time $25) but he would still be required to have 130% of $25,000 ($25,000 times 130% = $32,500) in his short sell account! Since he original deposited $26,000 in the account, Jeff must deposit an additional $6,500 to maintain the 130% margin for his short sell.

  20. SELLING SHORT: AN EXAMPLE • If Jeff ends up being right and the price of WOW decreases to $15 per share, Jeff’s liability would only be $15,000 (1000 shares time $15). His required margin would only be 130% of $15,000 ($15,000 times 130% = $19,500). Since Jeff original deposited $26,000 in the account, he can withdraw $6,500 and still maintain the 130% margin for his short sell.

  21. POTENTIAL DIFFICULTIES WITH SHORT SELLING: • Problems borrowing sufficient number of shares • Responsibility of maintaining an adequate margin • Liability for any dividends paid • Threat of being required to buy shares at undesirable prices if the margin is not maintained and/or the borrowed stock is called by its owners and cannot be replaced • Difficulty in obtaining up-to-date info on total short sales • Possibility of volatile prices should a rush to cover the lender’s shares occur • Potential for unlimited loss

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