|Understanding Short Selling - A Primer
Most investors buy stocks hoping that the price will rise. Short sellers, like Lang Asset Management, Inc., anticipate making a profit from declining prices. Expecting a drop in price, they sell the stock, and buy it back later at a lower price. The difference is their profit.
The natural question is: how can one sell a stock that one does not own? When you sell a stock short, the broker lends you the shares in order to allow delivery to the buyer. Later, when you buy the stock back (otherwise called covering), the broker reacquires the shares, and all is settled. For example, you believe XYZ Corporation stock price is too high, so you instruct your broker to sell short 100 shares at $50. The broker borrows 100 shares from another account, who previously approved such an arrangement, and delivers them to the buyer. The proceeds of $5,000 from the sales are credited to your account. If the stock were to fall to $30, you may then decide to buy it back for $3,000 and you make $2,000 profit.
Of course the stock may go up instead of down. Suppose it goes to $60, and you decide to purchase in order to minimize your losses. You buy the shares back and you have lost $1,000 ($5000-$6000). In fact, there is little difference from this situation than if you had bought the stock at $60 and watched it decline to $50. There is no limit on the amount of time you may remain short unless the broker "calls" the stock back because he must return the borrowed shares to the owner for some reason. This is a highly unusual situation, and only occurs with stocks that have a low level of liquidity. There are a few stocks that the broker cannot obtain. In such cases, you may not short that particular stock.
The broker requires you to post collateral for the short sale at a minimum rate of 50% of the value of the short position. If the collateral, less any unrealized loss, falls to 30% of the value of the original short position (or if the stock price rises so that the collateral minus losses equals only 30% of the short position), you receive a margin call. This means you must add additional assets to bring the value of the collateral, less losses, back up to 50% of the short position. We have never had a margin call.
There is an alternative method of calculating margins. Multiply the market value of the stocks short by 30%, and subtract this amount from the total market value. This remainder is your "cushion", and if divided by 1.3, reflects the dollar amount the account can decrease before a margin call is activated.
For example, if you sold a stock short for $5,000 (100 shares at $50), you would need to hold in the account a minimum amount of collateral equal to $2500 (50% of the value of the short position). Now suppose the price went to $60. You have an unrealized loss of $1,000, and the value of the account is now $4000 ($5000 minus the loss of $1000). Since $1500 represents only 30% of the original value of the short position ($5000), you are required to put up another $3,000. We arrive at this because the value of the short position is $6000 and 50% of that is $3000.
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