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Shorting is a strategy investors use to profit from a price decline.  It involves selling securities that the investor has borrowed with the intention of repurchasing them later at a lower price.  An investor who sells stock short borrows shares from a brokerage house and then sells them to another buyer.  Proceeds from sale go into the short-seller's account who must eventually buy those shares back at some point and return them to the lender.  The short seller expects that the stock price will go down, so when he buys back the stock to cover, he will pay less for the shares and keep the difference.

There are many reasons for short selling, especially when looking at history.  There have been times in the stock market where the only way to make money was from shorting.  Short selling helps maintain a liquid and rational market.

Covering and Called Away
When you buy back the shares you have borrowed and return them, this is called covering your short.  There are 2 situations in which you can be forced to cover (typically can hold a short indefinitely):

  1. When you get a margin call because you have hit your margin maintenance level
  2. When you have your short "called away"  (if the shareholders you borrowed from sell their positions).  This is rare, but it occurs occasionally when a lot of one particular stock is sold short.  Therefore, it is important to recognize that it can happen.

It is important to recognize that
you can lose more than you have.
The downside is limited because you will eventually get a margin call when your account reaches its margin maintenance level.  The best you can hope for in a short sale is the business will go under  and you never have to cover.  This will give you a 100% gain.

Short Interest
This is the total number of shares that have been sold short.  If you compare it to the shares outstanding, you can get a sense of the percentage of stock that has been sold short.  If a high percentage of shares outstanding has been sold short, it will be difficult to initiate new short positions because it may be difficult to find someone to borrow the shares from.  If too much of the stock is held short, this can lead to a short squeeze.

Short Squeeze
This occurs when a number of short sellers all try to cover their short positions at the same time.  This can drive the stock price up very quickly.  As the upward movement of the price actually induces more short-sellers to cover, it pushes the stock prices even higher.

Days to Cover
  • To find how many days' average volume it would take to cover all of the shorts, you can utilize the short interest ratio:  the number of shares sold short divided by the average daily volume in the stock
  • If a company has been shorted by a lot of people, it is actually a positive indicator because all those shorts have to buy back shares at some point

Dividends and Stock Splits
  • If a stock pays a dividend while you are selling it short, you actually have to pay the dividend to who you borrowed the stock from
  • Because you borrowed he shares and sold them, the company does not have to pay a dividend to you as you do not own any shares
  • The person you borrowed the shares from expects a dividend and you have to ante up
  • If a stock splits while you are shorting, you owe twice the amount of shares back to who you borrowed them from originally

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