Short selling

[Nyarlathotep]

Some of the gory details of the Enron case seem to revolve around various individuals "short selling" Enron Stock. My familiarity with the term was limited to knowing that it was a means to profit from a stock dropping in value, so I decided to look it up. Unfortunately, what I have turned up so far is short on detail, I gather that it involves somehow "borrowing" the stock, selling it, then buying it back at a lower price, thus making a profit.

But this still leaves me with several questions that I haven't found answers to that I (as a stock market novice) can understand. From whom does one usually borrow the stock? How does one go about doing so? Why does the lender permit this to be done? Doesn't it mean he takes a loss on the stock? How does the lender profit from the deal?

Also I have turned up several mentions that there are other means to make a profit off of a stock that is dropping in value that are sometimes erroneously called 'short selling' but are different from the procedure described above. What are some of those methods?

I know there are some people on this board who are fairly knowledgable about the stock market and can help me out, or at the very least point me to a resource that will answer my questions (though remember, if you do that, that I would be at the 'Stock Market for Dummies' stage). Thanks in advance.

[hgc]

Some of the gory details of the Enron case seem to revolve around various individuals "short selling" Enron Stock. My familiarity with the term was limited to knowing that it was a means to profit from a stock dropping in value, so I decided to look it up. Unfortunately, what I have turned up so far is short on detail, I gather that it involves somehow "borrowing" the stock, selling it, then buying it back at a lower price, thus making a profit.

But this still leaves me with several questions that I haven't found answers to that I (as a stock market novice) can understand. From whom does one usually borrow the stock? How does one go about doing so? Why does the lender permit this to be done? Doesn't it mean he takes a loss on the stock? How does the lender profit from the deal?

Also I have turned up several mentions that there are other means to make a profit off of a stock that is dropping in value that are sometimes erroneously called 'short selling' but are different from the procedure described above. What are some of those methods?

I know there are some people on this board who are fairly knowledgable about the stock market and can help me out, or at the very least point me to a resource that will answer my questions (though remember, if you do that, that I would be at the 'Stock Market for Dummies' stage). Thanks in advance.It is true that you sell short by borrowing the stock. You start by opening a margin account with your brokerage. This allows for 2 types of borrowing - stock for selling short and cash for buying long. In either case, you have to have a certain % (like 50%) of the borrowed portion available in the account to cover swings in the market that harm your position.

When you sell short, your brokerage will take the stock from other customers' accounts and/or from the house account, and make it available to you to sell. You are then on the hook to replace the stock by buying it on the market at some point in the future. The risk is different from long positions. When you buy a stock, the worst that can happen is that it'll go to 0 and you'll be out your investment. If you sell short, your upside liability is theoretically limitless, as the price of the stock can go through the roof instead of going down. Hence the margin %. If your margin % is 50%, and you've sold short 100 shares of IBM at $50, then you have to have $2500 worth of liquid assets in your account. If the price of IBM goes to $40, then you have to have $2000 available. If it goes the other way, then you'll have to start contributing into the account to cover your increased exposure.

[hgc]

Oh, other ways of making money from falling prices are by various derivitive instruments, such as options, futures, options on futures, collars, etc.

[Nyarlathotep]

Oh, other ways of making money from falling prices are by various derivitive instruments, such as options, futures, options on futures, collars, etc.


Unfortunately, that's pretty much what I have gotten from other things I've looked at. How does one make money from those things when stock prices drop?

[hgc]

Unfortunately, that's pretty much what I have gotten from other things I've looked at. How does one make money from those things when stock prices drop?Oh, that's easy. Sell 100 shares IBM at $50, and pocket $5000. Buy 100 shares IBM at $40, pay out $4000. Profit: $1000 (less commissions).

It's buy low, sell high, just in reverse order.

[Nyarlathotep]

Thanks hgc, that's understandable enough. How does the brokerage make any money from lending you the stock? If you sell it and pocket the proceeds then buy it back at a lower price, it would seem they would lose money every time someone sucessfully short sells. Are they just betting that enough people will end up tryg to short sell a stock that goes up, that it become profitable.

[hgc]

Unfortunately, that's pretty much what I have gotten from other things I've looked at. How does one make money from those things when stock prices drop?Oh, you were asking about the derivitives...

Options are simple. You can buy a call or issue a put. if I buy a call, I have the option to buy the underlying asset (stock) on or before the specified expiration date at the specified price (strike). If the specified price is below today's price then I've made a bet that the price is going down. If it's higher, then I've made a bet that the price is going up by the expiration date, but going up more than the strike price. If I issue a put, I'm on the other side of the equation. I have the obligation to execute (at the option of the caller) on or before the expiration date at the strike price.

This is an example of leverage -- using a small amount of money (the cost of the option) to control a large amount of money (the potential profit if the option is in the money on expiration). Borrowing money is another kind of leverage, where the small amount of money (the interest) gives me control over a large amount of money (the principal) that I can hopefully put to my best use in the time that I have it.

[pipelineaudio]

thanks for clearing this up! I was listening on NPR and just couldnt fathom how someone could make money by selling low till you explained it

[hgc]

Thanks hgc, that's understandable enough. How does the brokerage make any money from lending you the stock? If you sell it and pocket the proceeds then buy it back at a lower price, it would seem they would lose money every time someone sucessfully short sells. Are they just betting that enough people will end up tryg to short sell a stock that goes up, that it become profitable.Remember, the brokerage is not acting as a principal in the transaction, but rather as a ... broker. They are collecting on commissions for the buying and selling in these transactions. The principle of a margin account is not only that you get to borrow others' assets, but yours are also available for borrowing. But it comes out in the wash anyway. If you have a long position in your account which has been borrowed against by another customer, and you go to liquidate that position, the brokerage will just move some stuff around, and you'll never even know.

[Manny]

Also, the brokerage gets interest on the money. When you sell a stock you actually own, the $25,000 (say) goes into your money market account. When you sell that same stock short, the brokerage hangs onto the proceeds as security against the stock loan (indeed, they'll want some extra). So they invest that money at interest.

[Art Vandelay]

Okay, let's suppose that the stock is selling at $50/ share. You borrow a share, then you sell it for $50. Then the price drops to $40. So you buy it back, then return it to the person from whom you borrowed in the first place. You make $10. That's the theory. In practice, people don't actually go around moving stocks from one account to another. You just declare that you're going short, a broker arranges things, and you make or lose money depending on how the market goes.

1. From whom does one usually borrow the stock? How does one go about doing so?
2. Why does the lender permit this to be done?
3. Doesn't it mean he takes a loss on the stock?
1. Usually, you go through some sort of broker. In a way, this creates what amounts to virtual shares. You sell virtual shares, and someone else buys them. If the total number of virtual shares bought by a broker's customers is greater than the number sold, then the broker has to buy actual shares to cover the difference (or, as if often the case, virtual shares from yet another broker). If people sell more virtual shares than they buy, then the broker will borrow shares, then sell them to cover the difference (or just sell the virtual shares to another broker. The market's usually large enough that it comes pretty close to balancing out. Also, the actual sotck market and the virtual stock market are interconnected. The price of virtual shares starts out at the price of actual shares, but if more people are selling virtual shares than buying them, then that will drive the price of virtual shares down, and that in turn will drive the price of actual shares down. This happens so automatically that it's usually very difficult to see which is the cause and which is the effect (are lower actual share prices driving down virtual prices, or vice versa?).

2. The lender gets paid interest.

3. He only takes a loss if the stock goes down, and if the stock goes down, he would have taken a loss, anyway. At least this way he gets interest.

Also I have turned up several mentions that there are other means to make a profit off of a stock that is dropping in value that are sometimes erroneously called 'short selling' but are different from the procedure described above. What are some of those methods?A "put" is the right to sell a stock at a particular price. For instance, if I have a $50 put, that means that I can sell the stock, and the buyer is required to pay at least $50, regardless of what the actual market price is. A call is the right to buy a stock at a particular price. If you buy a call, that means you are getting the right. If you sell a call, that means you are giving someone else the right. So if you think the stock is going to go down, there are two ways that you can make money using puts and calls: buy a put, or sell a call. Let's say the current price is $50, and you pay $7 for a current-price put. Later, the price goes to $40. So all you have to do is buy a share at $40, then sell it for $50. Net profit: $3. Or, you could sell a current-price call. That means that you're promising that no matter what the current price is, you'll sell a share for $50. Well, if the price drops to $40, no one's going to take you up on that (no one's going to want to buy a share at $50). So whatever money you got from selling the call is pure profit.

Note that if you do both, that actually is effectively the same thing as going short.

Thanks hgc, that's understandable enough. How does the brokerage make any money from lending you the stock? If you sell it and pocket the proceeds then buy it back at a lower price, it would seem they would lose money every time someone sucessfully short sells.
To expand on what hgc said, the brokerage is just a middleman between people who want to sell and people who want to sell. It tries not to take much of a position at all, long or short. It take a long position from some customers, and a short one from others, and they try to make it balance out. They then make money on the commissions. As for the person going long on the stock, it's true that they lose money everytime the stock goes down, but obviously they wouldn't be buying the stock if they thought it's going down.

BTW, companies usually have contracts with their CEOs that prohibit the CEO from going short (and, in fact, require them to go long by a certain amount). I don't know if Enron had such clauses.

[drkitten]

Thanks hgc, that's understandable enough. How does the brokerage make any money from lending you the stock?

Commissions, and often on interest charged on your margin account.

[shemp]

You want evidences of short selling??? Well HERE IT IS!!! (http://www.rentamidget.com/)

[specious_reasons]

My company has a prohibition on all employees short-selling company stock. You're in effect betting against your own company - that's a bad thing.

You can find what the DoJ entered into evidence about Mark Lay here:
http://www.usdoj.gov/enron/exhibit/04-27/index.htm

I looked through the statement, and frankly, I don't know enough to comment exactly what was going on, but I think that the prosecutors possibly misrepresented the case. Lay purchased CALLs at $70 right after he sold short, so it looks like he was betting the stock was going to go up.

Possibly. It wouldn't surprise me that Mark Lay had some byzantine system for managing his stocks.

[a_unique_person]

Remember, the brokerage is not acting as a principal in the transaction, but rather as a ... broker. They are collecting on commissions for the buying and selling in these transactions. The principle of a margin account is not only that you get to borrow others' assets, but yours are also available for borrowing. But it comes out in the wash anyway. If you have a long position in your account which has been borrowed against by another customer, and you go to liquidate that position, the brokerage will just move some stuff around, and you'll never even know.

The brokerage is like the casino, he makes money either way.