Introduction to Short Selling
Short selling refers to the sale of securities that the seller does not own. This can be conducted only in a margin account. Profit is made when the initial sale price exceeds the subsequent purchase price, the opposite of a long position where the investor buys a security expecting its price to rise.
Steps in Short Selling
Short selling involves a reverse order of transactions compared to a long position. The investor sells the security first and later buys it back at a lower price to close the short position. Since the seller does not own the securities, they must borrow them, thus creating a short position until they buy back the shares.
Example of Short Selling
- Initial Sale: A client intends to short a stock at $10 per share. The broker lends the securities to the client, who then sells them in the market.
- Margin Deposit: The client must deposit enough margin (e.g., $5 per share) in addition to the sale proceeds to meet the required minimum balance.
- Market Monitoring: Both the client and firm continuously monitor the position. The client aims to buy back the stock at a lower price later.
- Closing the Position: If the client successfully purchases the stock at a lower price, they close the position and return the securities to the broker.
In some cases, the firm may require immediate return of the securities, forcing the client to buy back the shares regardless of the current price, which could result in a loss if the price has risen.
Risks & Precautions in Short Selling
Short selling involves borrowing stock, making it highly leveraged and riskier than long positions. Theoretically, the risk is unlimited as the stock price could rise infinitely. It’s crucial to implement precautionary measures, which will be discussed in detail in the subsequent sections of this chapter.
Margining Short Positions
Margin requirements differ for short positions due to inherent risks. In a short sale, no money is loaned to the client; instead, the client deposits additional funds into their account. Below are the minimum credit balance requirements:
| Selling Price Per Share |
Minimum Credit Balance |
| $2.00 and over |
150% of market value |
| $1.50 to $1.99 |
$3.00 per share |
| $0.25 to $1.49 |
200% of market value |
| Under $0.25 |
100% of market value + $0.25 per share |
| Securities eligible for margin |
130% of market value |
Example of Margin Calculations
Scenario 1: Price Decline to $4.00
- Current Market Price: $4.00
- Initial Short Sale Proceeds: $(5.00 × 100 shares) = $500.00
- Initial Margin: $250.00
Minimum Account Balance: 150% of $(4.00 × 100) = $600.00
Currently, excess margin: $750.00 (account balance) - $600.00 (required) = $150.00
Scenario 2: Price Decline to $1.60
Category Governed: $3.00 per share
Minimum Account Balance: $300.00
Currently, excess margin: $750.00 (account balance) - $300.00 (required) = $450.00
Scenario 3: Price Raise to $6.00
- Initial Short Sale Proceeds: $500.00
- Updated Minimum Account Balance: $900.00
- Initial Margin: $250.00
- Margin Deficiency: $900.00 - $750.00 (current account) = $150.00
Profit or Loss Calculation
Profit or loss in short selling follows the same formula as long positions: the difference between proceeds and purchase cost. Below are example scenarios:
Scenario 1: Price Decline to $1.60
Profit Calculation:
$$
\text{Proceeds} - \text{Cost to Cover} = (100 \times 5.00) - (100 \times 1.60) = 500 - 160 = 340 \text{ (Profit)}
$$
Scenario 2: Price Raise to $6.00
Loss Calculation:
$$
\text{Proceeds} - \text{Cost to Cover} = (100 \times 5.00) - (100 \times 6.00) = 500 - 600 = -100 \text{ (Loss)}
$$
Time Limit and Covering a Short Position
Short positions can be maintained indefinitely, given the stock remains viable, equivalent securities can be borrowed, and adequate margin is maintained. If securities become difficult to borrow, the client must repurchase the stock to cover the short.
Reporting & Compliance
Dealers must confirm whether sales are short or long. Short sales must be marked properly for processing and be reported by exchanges like TSX.
Frequently Asked Questions (FAQs)
Q: Why is a margin required for short positions?
A: Margin is required because the investor borrows the stock and the transaction involves higher risk.
Q: What is the maximum risk in a short sale?
A: The risk is theoretically unlimited as the stock price can rise indefinitely.
Q: How long can a short sale position be maintained?
A: Indefinitely, as long as the stock remains listed and there are borrowable shares.
Q: What happens if I can’t borrow the stock anymore?
A: You must buy the shares to cover the short sale regardless of the current market price.
Key Terms Glossary
- Margin Account: A brokerage account in which the broker lends the client funds to purchase securities.
- Short Position: Selling securities you do not own with the intention of repurchasing them at a lower price.
- Long Position: Buying securities to hold, expecting their price to rise.
- Margin Call: A request from a broker for the margin account holder to deposit additional funds or securities to cover potential losses.
Key Takeaways
- Short selling involves selling borrowed shares with the aim of repurchasing them at a lower price.
- Margin is mandatory due to the high risks associated with short selling.
- Time limits on short sales depend on the borrowability and list status of the securities.
- Profits and losses are based on the difference between the short sale proceeds and the repurchase cost.
📚✨ Quiz Time! ✨📚
## What is the primary goal of short selling?
- [ ] To buy low and sell high
- [x] To sell high and buy low
- [ ] To hold a security until it appreciates
- [ ] To avoid using margin accounts
> **Explanation:** Short selling is a strategy where an investor sells a security they do not own with the intention to buy it back later at a lower price, thereby making a profit from the price difference.
## In which type of account can short selling be done?
- [ ] Cash account
- [ ] Registered Retirement Savings Plan (RRSP)
- [x] Margin account
- [ ] Tax-Free Savings Account (TFSA)
> **Explanation:** Short selling can only be done in a margin account because it involves borrowing securities, which requires collateral.
## What must be deposited into the account when initiating a short sale?
- [ ] Only proceeds from the short sale
- [ ] No deposit is required
- [x] The proceeds from the short sale plus additional margin
- [ ] Partial proceeds from the short sale
> **Explanation:** The proceeds from the short sale are deposited into the client's account along with additional margin to meet the required balance for potential losses.
## What happens if the price of the stock sold short rises instead of falls?
- [ ] The client incurs no loss
- [ ] The client gains a profit
- [ ] The client receives a dividend
- [x] The client incurs a loss
> **Explanation:** If the stock price rises, the client will have to buy back the higher-priced stock, incurring a loss since they sold it at a lower price initially.
## What is the theoretical risk of short selling?
- [ ] Loss is limited to the sale price
- [ ] Loss is no more than the margin deposited
- [ ] Loss is capped at a fixed percentage
- [x] Loss is unlimited
> **Explanation:** Theoretically, short selling has unlimited risk because the price of the stock can rise indefinitely, creating a potentially unlimited loss.
## What specific benefit does the investment dealer gain from lending securities to a short seller?
- [ ] Increased security holdings
- [x] Ability to use short sale proceeds in their business
- [ ] Reduction in transaction costs
- [ ] Immediate profit on the securities lent
> **Explanation:** The investment dealer can use the money put up by the short seller in the firm's business or in interest-earning activities.
## Which of the following is a requirement for maintaining a short sale position?
- [ ] The stock must be delisted
- [x] Sufficient margin must be maintained
- [ ] The stock price must go up
- [ ] The position must be closed within 30 days
> **Explanation:** The short sale position can be maintained as long as sufficient margin is maintained in the account and the stock can still be borrowed.
## What must an investment advisor do when entering an order for a short sale?
- [ ] Nothing special, treat it as a normal sale
- [ ] Notify the client
- [x] Clearly mark the sell-order ticket "Short (or S)"
- [ ] Mark the sell-order ticket with the current market price
> **Explanation:** The investment advisor must clearly mark the sell-order ticket "Short (or S)" so the trading department can process the order properly.
## What are the minimum credit balance requirements for short sales of listed equities priced at $2.00 and over?
- [x] 150% of market value
- [ ] 100% of market value
- [ ] 130% of market value
- [ ] $3.00 per share regardless of price
> **Explanation:** For listed equities priced at $2.00 and over, the minimum credit balance requirement is 150% of the market value.
## Which of the following scenarios describes a profit from a short sale?
- [ ] The sale price is $5.00, the buy-back price is $6.00
- [ ] The sale price is the same as the buy-back price
- [x] The sale price is $5.00, the buy-back price is $1.60
- [ ] The buy-back price is higher than the sale price
> **Explanation:** A profit from a short sale occurs when the stock is sold at a higher price ($5.00) and bought back at a lower price ($1.60), resulting in a gain.