The Mechanics of Shorting for the High Level Investor

By Paul Mladjenovic

The essence of short selling is that the stock you’re choosing to go short on is first borrowed by the broker, placed in your account, and sold instantly. If you’re correct and the stock goes down, you can then buy back the stock at a profit and return it from whence it came.

Keep in mind that “borrowing stock” is the heart of the short sale. The stock has to be returned. The broker typically borrows it from other clients (a third party, done even without the party’s knowledge). Although that doesn’t sound right, but it’s common practice, and the broker does guarantee the transaction for the stock owner, so there’s nothing wrong here in that regard.

Shorting can be done only in a margin account. It requires approval from the brokerage firm, and you need to have sufficient cash and collateral (in the form of other stocks) to cover your potential liability in the event that your shorting strategy generates losses. Speak to your brokerage firm’s customer service department for full details on the firm’s shorting requirements, margin maintenance, and guidelines to minimize losses.

Suppose that XYZ stock is trading at $40 per share. You believe it will go down, and you believe that will happen soon. So that you can take advantage of this potential move in the stock, you decide to go short on XYZ.

You call your broker, who then proceeds to borrow 100 shares of XYZ from a third party (which party is immaterial to you) for your short sale. The broker then sells this stock at the market price of $40 per share to receive total proceeds of $4,000. This money, which is now sitting in your account, is considered a liability for you, and you pay interest on this amount. You have an obligation to ultimately return 100 shares to your broker, who will then return the stock to the third party from whom it was borrowed initially.

Several weeks pass, and XYZ stock falls to $22. At this point, you want to lock in your profit and get out, or close out the trade. You call the broker and instruct him to “close out and cover my short trade on 100 shares of XYZ at the market.” The broker will then buy 100 shares at $22 and return the acquired stock to the third-party source.

The end result is that your short-selling trade worked out very well. You “sold high and bought low” and earned a profit. In other words, you sold XYZ stock initially at $4,000, you bought it back at $2,200 to cover and close out the trade, and you made a profit of $1,800 ($4,000 minus $2,200), minus commissions.

But what if the trade didn’t work out? As you know, the short term can be unpredictable and irrational. That’s the market! Suppose that XYZ stock doesn’t fall in the short term; it rises. What then? If XYZ rises to $70 per share, there’s a serious margin issue. Although you have $4,000 in cash sitting in your account, the full amount needed to cover your transaction is $7,000. You’ll get the dreaded margin call, and you’ll need to either increase the cash in the account or add (or have) marginable securities in the account. If the stock does go to $7,000 and you don’t have marginable securities (which act like collateral so that the margin liability is secure), then you’ll have to cough up the extra $3,000 — and that’s a lot of coughing!

In short selling, the most you can make is 100 percent (in this case, the stock goes to zero, meaning that the company most likely went bankrupt). But if you aren’t careful, you could lose more than 100 percent. In the case of XYZ, if the stock zooms to $85, then your loss would be a whopping $4,500! In that case, you either cough up the extra dough or take the next flight to Burma.