Table of Contents
Chapter 1: Introduction to Short Selling Stocks
Chapter 2: Short Selling Terminology
Chapter 3: Short Selling Limitations and Risks
Chapter 4: Who Should Get Involved in Short Selling
Chapter 5: Factors to Consider before Short Selling
Navigate This Page
Chapter 2: Short Selling Terminology
– Margin Account
– Short Interest
– Covering or Covering the Position
– Short Squeeze
– Called Away
Chapter 2: Short Selling Terminology
Short selling can be complicated and a basic understanding of how it works is essential if you want make money from a fall in stock prices. Gaining a good grasp of the various terms used with these transactions will help you in understanding short selling.
- Margin Account
- A margin account needs to be opened by the investor to conduct a short sale. The proceeds from the sale of the stock will be reflected in the account as will the debit from the purchase of shares plus any commissions, charges, brokerage and other costs.
- Short Interest
- Short interest is the number of shares of a company that have been sold ‘short’. This figure gives a good idea about what the market sentiment is regarding the expected future performance of a stock. If the short interest is high, it means that many investors have shorted on the stock believing the price is set to go down. In the stock market, sentiment plays a huge role in determining the fate of stocks. A heavily ‘bearish’ sentiment on a stock contributes to a fall in its price.
The short interest on a stock can be determined from the exchange on which it is traded. NYSE and NASDAQ list short interest of stocks as a percentage of shorted stocks sold against the total float (total number of company shares available in the market for trading).
- Covering or Covering the Position
- A short seller ‘covers his position’ when he buys back the same number of shares that he has borrowed. He is said to have closed a short position when he does this. Once he has bought the shares back, any price fluctuations no longer affect him. Sometimes also referred to as ‘buying to cover’, this transaction is carried out when the short seller expects the share price to start moving up or when he just wants to limit his losses.
- Short Squeeze
- A short squeeze occurs when a number of short sellers start buying back the same stock to fulfill their obligations. This will typically happen when a stock that has been declining in price for a while starts showing signs of recovery. All the short sellers with exposure to this stock will crowd the market to buy back at the lowest possible price so that their gains remain intact.
This can act like a ‘self-fulfilling prophecy’, as the stock value, because the sudden huge demand, pushes the price of the stock up faster than it would have done in normal circumstances. When such demand appears in the market, it is called a short squeeze.
- Called Away
- A short seller is typically given a free rein to decide how long he wants to hold on to the securities before he returns them. This gives him the freedom to analyze the markets and time his buy back at the lowest price of the stock. However, the broker can ‘call away’ the short seller and force him to make good on the loan. This usually happens when the stock price is rising instead of falling and the broker fears that the short seller may not be able to recompense the shares.
Also called a ‘margin call’, ‘calling away’ is equivalent of a lender asking the borrower to fulfill his obligations immediately instead of waiting for the stock price to fall. When a short seller is ‘called away’, he has no choice but to buy back shares at current market price to repay the broker. He does not have the option to wait for prices to fall so that he can make money on his investment.
In our earlier example, Peter borrowed 100 shares of Kiddy Toys from his broker, at a price of $25 a share to get $2,500 deposited in his margin account. He hoped that the price of the stock would fall. If the price instead increases to $30, Peter’s gamble has failed. His broker can issue a call for him to return the shares immediately.
Now Peter has no choice but to buy 100 shares at $30, spending $3,000. He has incurred interest on the broker’s loan as well as lost $500 of his own funds in the investment. As the shares are taken on loan, the broker wields substantial control over the trade.
Next Chapter: Short Selling Limitations and Risks
