Shorts

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aarondenal's picture
aarondenal
Status: Bronze Member (Offline)
Joined: Oct 24 2010
Posts: 59
Shorts

I have two newby questions about Shorts:

1.  Can anyone point me to a fairly short (not really a pun, is it?) but extremely articulate explanation of how they work in general?

2.  If one has a short position on a stock that goes higher, is that person responsible for covering the full value of the stock or just the split?  (eg.  short at 20 goes to 25 does the investor owe 5 or 25?)

Thanks so much!

Johnny Oxygen's picture
Johnny Oxygen
Status: Diamond Member (Offline)
Joined: Sep 9 2009
Posts: 1441
Re: Shorts

This is as much as I know.

Yo Machinehead!

aarondenal needs your help.

Dogs_In_A_Pile's picture
Dogs_In_A_Pile
Status: Martenson Brigade Member (Offline)
Joined: Jan 4 2009
Posts: 2484
Re: Shorts

aarondenal wrote:

I have two newby questions about Shorts:

1.  Can anyone point me to a fairly short (not really a pun, is it?) but extremely articulate explanation of how they work in general?

2.  If one has a short position on a stock that goes higher, is that person responsible for covering the full value of the stock or just the split?  (eg.  short at 20 goes to 25 does the investor owe 5 or 25?)

Thanks so much!

Here's the Reader's Digest large print version.

When you short a stock you can either sell shares of stock that you own or you can "borrow" the shares from your brokerage.  When you sell, if you did it correctly, you are selling short in front of a downward movement in price.  You get paid whatever price you sold - i.e., you short sell 1000 shares of Microsoft at $25 and $25,000 (less brokerage fees) instantly goes into your account as taxable, spendable income.  You are still responsible for delivering the 1000 shares, either from your inventory or from the shares your brokerage "borrowed".  Let's say MSFT drops to $22.  You buy back the stock to close the short for $22,000 and pocket $3,000 in profit.  The transaction is settled and closed at this point - the shares are all accounted for.

Where it gets hinky is when the stock goes up in price.  If you have "borrowed" the stock, you have to deliver the 1000 shares at $25 per share, but if your brokerage has to pay $30 per share to cover what they borrowed and let you sell, you will have to pay $30,000 to deliver 1000 shares at $25 per share - in other words, you lose $5000, but you had to have and pay $30,000 to do so.

Most brokerages have requirements to have sufficient cash in your account to cover the short in order to be able to sell short - or you have to own enough shares of the stock you are short selling.

There are time requirements - at some point your brokerage is going to require that you deliver the stock so if you get stuck in a scenario where you sold short and the price starts rising, once you have burned your margin (cash in your account) the brokerage is going to deliver the shares at the short sell price and you will need to come up with the difference.  In the example of MSFT, you sold short at $25 and it went to $31.  Your brokerage decides that you are done and you have to deliver the shares.  So not only do you have to use the $25,000 you made from the sale to open the short, now you have to come up with another $6,000 (plus fees) to capture the price rise and what you had to pay to acquire the shares.

In other words, you can't sell short and pocket the money and hold the position as long as it takes until it goes your way.

This is a 40,000 foot flyover and a greatly simplified "short" version. - hope it helped.

machinehead's picture
machinehead
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Joined: Mar 18 2008
Posts: 1077
Re: Shorts

Dogs_In_A_Pile wrote:

When you short a stock you can either sell shares of stock that you own or you can "borrow" the shares from your brokerage.  When you sell, if you did it correctly, you are selling short in front of a downward movement in price.  You get paid whatever price you sold - i.e., you short sell 1000 shares of Microsoft at $25 and $25,000 (less brokerage fees) instantly goes into your account as taxable, spendable income.  You are still responsible for delivering the 1000 shares, either from your inventory or from the shares your brokerage "borrowed".  Let's say MSFT drops to $22.  You buy back the stock to close the short for $22,000 and pocket $3,000 in profit.  The transaction is settled and closed at this point - the shares are all accounted for.

Where it gets hinky is when the stock goes up in price.  If you have "borrowed" the stock, you have to deliver the 1000 shares at $25 per share, but if your brokerage has to pay $30 per share to cover what they borrowed and let you sell, you will have to pay $30,000 to deliver 1000 shares at $25 per share - in other words, you lose $5000, but you had to have and pay $30,000 to do so.

Most brokerages have requirements to have sufficient cash in your account to cover the short in order to be able to sell short - or you have to own enough shares of the stock you are short selling.

Let's say you had $10,000 cash in your brokerage account, and you shorted $25,000 of borrowed MSFT shares as Dogs described. Your brokerage statement will look something like this after the sale:

Cash . . . . . . . . . . . . . . . . . . . .. . . . . . . $35,000
Short 1,000 sh MSFT @ $25 .. . . . . .(25,000)
Account Equity . . . . . . . . . . . . .  . . . . .$10,000

Your equity is still $10,000, as it was before the short sale. If the price of MSFT goes down to $22, then your equity goes up to $13,000 -- the short position is a liability, so it subtracts from equity. If MSFT goes up to $30, then your account equity shrinks to $5,000.

The cash is not really yours to withdraw, because it serves to guarantee that you have the wherewithal to buy back the shorted shares. The broker is not going to let your equity go to zero, or even approach it, without issuing a margin call (forcing you to either buy back some shorted shares, or deposit more cash).

So typically, your $35,000 cash is going to be invested in a money market fund or in T-bills. On the other hand, you are responsible for paying dividends on the shorted shares, so the cash in your account will be debited each time MSFT pays a dividend. 

Interest earnings on cash are taxable (in a taxable account). The short sale (and the cash that it raised)  isn't taxed until it's closed out, as a short-term or long-term capital gain or loss.

aarondenal's picture
aarondenal
Status: Bronze Member (Offline)
Joined: Oct 24 2010
Posts: 59
Re: Shorts

Thanks guys.

So, in the case of silver and JP Morgan, the amount the original short is purchased at cannot be changed, right?  So assuming that they have purchased shorts at a much lower value (than current market value) the only way for them come out without major losses would be if the value goes back to what it was when the short was purchased?

Also, would it be fair to think they are acting as their own brokerage?

machinehead's picture
machinehead
Status: Diamond Member (Offline)
Joined: Mar 18 2008
Posts: 1077
Re: Shorts

aarondenal wrote:

Thanks guys.

So, in the case of silver and JP Morgan, the amount the original short is purchased at cannot be changed, right?  So assuming that they have purchased shorts at a much lower value (than current market value) the only way for them come out without major losses would be if the value goes back to what it was when the short was purchased?

Also, would it be fair to think they are acting as their own brokerage?

Shorting commodities is different from shorting stocks. When you short silver on the Comex, you are not actually borrowing physical silver and selling it for cash. A sale of physical for cash only happens if you hold the futures position until a delivery notice is issued.

Since shorting commodities doesn't involve borrowing the physical, it doesn't produce a cash credit in your futures account. Your starting equity is simply adjusted day by day, as the contract value is marked to market. Most futures contracts end up being closed out or rolled over before delivery, so the stock shorting procedure of borrowing shares, selling them for cash and later buying them back isn't pertinent.

For JP Morgan or anyone, if you short something at a given price and the price then rises, you have lost money. The choices are to cut losses, hold on hoping the market reverses, or to 'double down' so that only half the price rise has to be reversed in order to break even. Doubling down is tempting for players with access to unlimited, zero-percent free money.

Johnny Oxygen's picture
Johnny Oxygen
Status: Diamond Member (Offline)
Joined: Sep 9 2009
Posts: 1441
Re: Shorts

I was under the impression that JP Morgan was 'naked' short selling silver not just shorting it.

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