Short Selling

Short selling is hard enough to get your head around without getting into all the particulars. If you have a basic understanding of short selling, then you probably know that as a short seller, you are required to make up for any benefits a long investor would receive if he or she had actually owned the stock.

When you short a stock, you are borrowing the stock from an investor or broker, then selling those shares on the open market to a second investor. Even though you borrowed and sold the shares to another investor, the transaction between you and the lender is still listed on the books as if the lender is still long on the stock and you are short on the stock (even though that person no longer owns the stock).

Because that original investor who was kind enough to lend you the stock is no longer an actual shareholder with the company, the short seller is required to make up for any benefits the investor would have received had he or she actually still owned the stock.

In other words, if a company pays a dividend to shareholders, the second investor who bought the shares from the short seller would get the dividend check from the company. But because the original investor is no longer a shareholder of record (because the second investor owns those shares now), then the short seller must pay the dividend out of his or her own pocket.

Finally, when the short seller decides to close out the short position, he or she buys shares on the open market (from a third investor) and then gives the shares back to the original investor, who closes out the short position and puts everything back to square one.

The major difference between the stop-loss order used by an investor who holds a short position and one used by an investor with a long position is the position in which it is placed. The individual with the long position wishes to see the price of the asset increase, whereas the individual with the short position wants the price of the asset to decrease and would be negatively affected by a sharp increase. To protect against a large price increase, the short seller can use a buy-stop order, which is an order that will turn into a market order once the upper price has been reached. Conversely, the individual who holds the long position can set a stop-loss to be triggered when the price falls below a certain level.

For example, if a trader is short selling 100 shares of ABC Company at $50, he or she might set a buy-stop order at $55 to protect against a move beyond this price. If the price happens to rise to $55.25, the short seller's order would be triggered, resulting in the trader buying the 100 shares back near $55. A word of caution: on an extremely large increase in price, the buy-stop market order could be triggered at a substantially higher price than $55.

A different way that a short seller can protect against a large increase like the one mentioned above is by purchasing an out-of-the-money call option. If the price does experience a move upward, the trader can exercise his or her option to buy the shares at the strike price and then provide them to the lender of the shares used in the short sale.

stock splits do not affect short sellers in a material way. There are some changes that occur as a result of a split that do affect the short position, but they don't affect the value of the short position. The biggest change that happens to the portfolio is the number of shares being shorted and the price per share.

When an investor shorts a stock, he or she is borrowing the shares, and is required to return them at some point in the future. For example, if an investor shorts 100 shares of ABC at $25, he or she will be required to return 100 shares of ABC to the lender at some point in the future. If the stock undergoes a 2:1 split before the shares are returned, it simply means that the number of shares in the market will double along with the number of shares that need to be returned.

When a company splits its shares, the value of the shares also splits. To continue with the example, let's say the shares were trading at $20 at the time of the 2:1 split; after the split, the number of shares doubles and the shares trade at $10 instead of $20. If an investor has 100 shares at $20 for a total of $2,000, after the split he or she will have 200 shares at $10 for a total of $2,000.

In the case of a short investor, he or she initially owes 100 shares to the lender, but after the split he or she will owe 200 shares at a reduced price. If the short investor closes the position right after the split, he or she will buy 200 shares in the market for $10 and return them to the lender. The short investor will have made a profit of $500 (money received at short sale ($25 x 100) less cost of closing out short position ($10 x 200). That is, $2,500 - $2,000 = $500). The entry price for the short was 100 shares at $25, which is equivalent to 200 shares at $12.50. So the short made $2.50 per share on the 200 shares borrowed, or $5 per share on 100 shares if he or she had sold before the split.

Neither a long nor a short position is materially affected by a stock split - the value of the position does not change. So, if a company has announced that it will split in six months, it should have no bearing on the attractiveness of the short investment.