Shorting

Shorting is the sale of an asset that is not currently owned by the seller. In the stock market, shorting stock is accomplished much in the same way as selling stock that is already owned. The machinations behind the procedure are somewhat different however. Shorted stock must first be borrowed from a third party. This may be the broker directly, or for a fee, the broker can locate the stock on the trader’s behalf using stock that other clients have signaled as available for lending. With the stock available, the traders proceeds to make a sale. Brokerage commissions are paid as before. In addition to this, an ongoing loan fee, calculated on the value of the stock shorted, is paid to the broker. Depending on how difficult the stock is to borrow, and the level of interest rates, the costs may vary widely. If the broker has used stock from a third party client account, this borrowing fee will be shared with that client.

Thinly traded stock, smaller companies pursuing a takeover strategy, of firms suffering from poor earnings whose continued existence is in doubt will all have high costs of borrowing. On occasion, a stock based merger arbitrage spread may at first appear to be too good to be true. If dividends are not the explanation, the spread may be so wide due to lack of availability of stock to borrow and subsequently sell short.

To restrict abuse of the short selling ability the uptick rule was introduced in 1938. This restriction states that shorting stocks is only allowed on upticks. The trade price must be at a price above the last traded price of the stock, or the same as the last traded price as long as the most recent movement was upward. This rule was removed in 2007 and has subsequently been replaced by a modified uptick rule. Various global exchanges has their own version of this rule and traders are advised to familiarize themselves with these local characteristics before trading. Futures trading does not have this restriction neither does spread betting or CFD trading facilities.