The stock market provides significant rewards to those who can buy the right stocks at the right time. There is nothing more exhilarating than buying shares of a company for a low price and watching it climb higher and higher.

However, investors watching the market have also seen that prices can move just as remarkably in the opposite direction. Prices can plunge. And because of this, savvy investors understand that the market offers another rewarding opportunity. You can profit from a falling stock price just as easily as you can from rising stock prices, which is done by selling short or shorting shares. Traders who short shares profit from falling stock prices.

Shorting shares is often viewed as an unscrupulous way to make money. However, it does play an important economic role. The stock market is a system that allows the public to place values on publicly traded companies. But if the price is viewed as too high, there is no way to vote for a lower price if youre only allowed to buy. Because of this, regulators allow traders to sell short shares, which act as a way to efficiently get prices in line with public opinions.

Short selling can also be used by investors as a way to hedge a long-term portfolio. Having short shares acts to reduce the price fluctuations of a portfolio and can actually increase the returns for a given level of risk.

Shorting shares is therefore essential for an efficient market as well as balanced portfolio but there are significant risks. Because of this, were going to explore the mechanics of short selling.

Long and Short

In traders lingo, you are long a stock if you own it. Investors who are long stock profit from buying it for a relatively low price and selling it for a higher price.

Short sellers make money in the same way as long positions but by entering the trades in the opposite order. This should make intuitive sense. If a long position profits by buying low but selling for a higher price, you should be able to profit by selling first and buying it back at a lower price.

If the concept of short selling is confusing, think about the transactions on your account when you buy stock. Your broker will debit your account for the cost at the time of purchase and then credit your account the amount from selling those shares. If the credit is bigger than the debit, you made money.

Short positions behave in the opposite manner. First, your broker will credit your account for the sale of the stock and then debit your account for the purchase price when you close out the short position. If the debit is less than the initial credit, you can make a profit from falling stock prices. In both cases, the debit must be less than the credit. Short sellers just enter the trades in the reverse order.

Three Requirements

Before you can short a stock though, there are three basic requirements that must be met. First, you must sign a margin account agreement with your broker. After your account is approved, the margin agreement allows you to borrow shares of stock to short. In addition, a margin account allows you to borrow money against long shares of stock in your account.

Second, the stock must be marginable and these requirements are set by the Federal Reserve. In order to qualify as marginable, a stock generally must meet the following criteria:

• Average trading price of $5 or more for the past 30 days
• Minimum daily volume greater than 1% of the outstanding shares
• Cannot be traded on the OTCBB (Over-the-counter Bulletin Board)

The third requirement is that you must deposit 50% of the short stock value with your broker. This initial deposit is called the Regulation T, or Reg T amount. (Regulation T is the Federal Reserve Boards regulatory section dealing with the extension of credit for brokers.) For instance, if you short 100 shares at $50 then the stock value is $5,000 and you must deposit half that or $2,500. The main point to understand is that even though you receive money from shorting the stock, you still must have enough cash in the account to cover the margin requirement.

The reason for this requirement is that you must buy back the shares at a later date and theres no telling how high the price of that security might be and therefore no way to define the maximum risk. To combat this problem, brokers withhold money from your account as security, which is called a margin requirement. As with any regulation, brokerage firms are allowed to make the rules stricter so it is possible that your broker may require more than a 50% margin requirement.

There used to be a fourth requirement, which was called the uptick rule. The uptick rule was eliminated in July 2007; however, after the 2008 market turmoil, there is much debate about reinstating the rule. In the event that happens, lets take a look at the uptick rule.

With an active uptick rule, in order to execute the short sale, the trade must take place on an uptick. To understand an uptick, you must realize that actively traded stock prices change nearly every second of the trading day. In fact, you can get a listing of each and every trade that occurred during the day through a report called time and sales. Imagine that you are looking at such a report for IBM and see a long sequence of prices that occurred during the day. The first trade of the day executed for $99.90 and then continued with $100, $100.05, $100, $100, $99.90, $100, $100and so on.

The first trade in the list is $99.90. The second trade for $100 took place on an uptick since it is greater than the first trade at $99.90 (as shown by the first green arrow).

The third trade in the list for $100.05 also took place on an uptick since it is greater than the second trade at $100.

The fourth trade in the list for $100 is less than the previous trade at $100.05 so that is occurred on a downtick as shown by the first red arrow.

If any trade price in the list is higher than the previous trade, it is said to have occurred on an uptick. If any trade price is lower than the previous trade, it occurred on a downtick. The diagram below represents the prices used in our IBM example:

What happens if two consecutive prices are equal? These situations create a couple of minor variations of the uptick and downtick definitions. One is called a zero-plus tick and the other is a zero-minus tick. If two trades occur for equal prices then you must back up to the last point where a price change took place and it is that price that determines how we will classify it. If the last price was lower, it is a zero-plus tick. If the last price was higher then it is a zero-minus tick.

For example, in the above diagram, how would we classify the fifth trade in the list for $100? Because the previous trade also took place at $100, we cannot say it is an uptick or downtick. Instead, we must continue looking to the left until we find the first trade that is different from $100. That happens to be the third trade for $100.05. Because the fifth trade is less than this amount, wed say that the fifth trade occurred on a zero-minus tick.

Similarly, the very last trade in the list is for $100, which also matches the previous trade. To classify the last trade, wed therefore have to look to the left until we find the first price different from $100. That price is $99.90. Because the last trade is higher than $99.90, wed say the last trade occurred on a zero-plus tick.

All short sales of stock must take place on either an uptick or a zero-plus tick. There are some exceptions with assets such as ETFs (Exchange Traded Funds) which are exempt from the uptick rule. However, the uptick rule always applies for shares of stock.

The uptick technicality is nothing you need to be concerned with as the exchanges will monitor the order and only execute it on an uptick. The main point to understand is that it is possible, although unlikely, for your short sale order to not execute even with a market order if the uptick rule is in effect.

The uptick rule was implemented by the SEC (Securities and Exchange Commission) after the Crash of 29. It was developed to prevent traders from entering short sales while the price of that security is declining. Short selling would nearly g uarantee that the stock price will fall and the trader will profit and it was the practice of short selling that many blamed for the crash.

Now that you understand some of the technicalities, lets run through the accounting of a short sale. Assume you are bearish on ABC stock and want to sell it short. Let’s run through a short sale and see how it works.

Example:

Assume ABC is currently $50 and you think it will fall and would like to short 100 shares. The total value of this position is $50 * 100 = $5,000 so you need to post 50% (the Reg T amount), or $2,500, with your broker.

Your account will show the following figures:

Credit = $7,500

- MVS = $5,000

Equity $2,500

These figures may not show in a neat stack as weve shown here but they will appear somewhere on your account. The important point is to understand what they all mean.

The credit shows the amount of cash sitting in the account due to the short sale. Five thousand dollars were received from selling the shares while $2,500 was deposited by you for a total of $7,500.

The MVS line stands for market value short and is the current market value of the shares. It represents the amount of money that must be paid if you wanted to close the position now.

It is calculated by the number of shares short multiplied by the current market price; in this example, 100 shares * $50 stock price = $5,000 market value short. The MVS value will obviously change daily based on the closing price of the stock. Some of the more sophisticated platforms will show the current price of the stock in real time so you may see MVS fluctuate all through the trading day.

The equity shows how much equity you have in the short position and is found by subtracting MVS from the credit balance. At this time, all of the equity is due to your $2,500 cash deposit.

Notice that if we take the $2,500 equity and divide it by the $5,000 market value short (MVS) that gives you 50% equity, which is the required Reg T amount. Your equity percent is always found by dividing equity by MVS:

Equity / MVS = Equity Percent

Let’s assume ABC falls to $40 per share. The market value short is now $4,000 and your account looks like this:

Credit = $7,500

- MVS = $4,000

Equity $3,500

Notice that the credit balance did not change; it is simply cash sitting in the account. As stated before, the market value short (MVS) will change in response to the stock price, which in turn changes your equity. If the MVS falls, your equity will rise and vice versa. This is an accountants way of showing that the short-sale trader profits from a decrease in the stocks price. With the MVS at $4,000, your equity has increased from $2,500 to $3,500.

In this example, the stock fell 20% from $50 to $40, giving you a 40% increase in equity. The reason you doubled the percentage move of the stock is because you only posted 50% of the requirement which creates 2:1 leverage.

Because your equity moves in the opposite direction of the stock, short positions are one of the most dangerous as there is no theoretical upper limit on a stock price. For example, if you buy a stock for $50, the most you can lose is $50 if the company goes bankrupt and the stock is trading for zero. However, if you short a stock at $50, there is no upper limit; the stock price can theoretically keep climbing higher and higher. If it climbs quickly, you can be left with negative equity meaning that you owe your broker money just to get your account back to a zero balance.

For instance, if ABC jumps to $80 the next day on a buyout rumor, your account would look like this:

Credit = $7,500

- MVS = $8,000

Equity — $500

In other words, you sold stock for $5,000, which would now cost $8,000 to cover for a $3,000 loss. Because $2,500 of that loss was your initial equity, you still owe your broker $500 and that will just get your account back to a zero balance.

Because of this risk, brokerage firms have minimum equity requirements (called the house requirement) in an attempt to prevent you from slipping too far in debt. Most firms require about 30% or 35% of the market value short. Note that this is different from the initial Reg T amount, which is always 50%. After the short sale, your account equity is allowed to fluctuate down to the house requirement before your broker requires you to bring in more money. If you do not deposit more money, the broker may close the position for you.

For instance, assume you shorted the stock at $50 but it later rises to $60. Your account now looks like this:

Credit = $7,500

- MVS = $6,000

Equity $1,500

Your account now has $1,500/$6,000 = 25% equity. If the broker requires your account to be at 35% then you should have total equity of $6,000 * 0.35 = $2,100. Because your account only has $1,500 equity, the broker will require that you send in the $600 difference by issuing a maintenance call. In the brokerage business, we would say that the account is in maintenance.

Technically, any maintenance call, regardless of the amount, is due immediately which generally means by the close of business that day. However, depending on the size of the maintenance call, the broker may give you some time to round up the cash perhaps a day or two. Just remember they are not required to give you any time at all. Of course, if you have additional cash sitting in your account (money market) it will automatically be swept to meet this maintenance call.

There are other ways to meet a maintenance call other than by depositing a check. You could, for example, sell shares of stock or other assets to raise the cash. But to keep the example simple, lets assume you deposit cash.

If you deposit $600, it will be added to your current $7,500 balance for a total of $8,100 and your account looks like this:

Credit = $8,100

- MVS = $6,000

Equity $2,100

Your equity percent is now $2,100/$6,000 = 35% and your account is out of maintenance at least for now. Of course, you are always free to deposit more money than required by the maintenance call in order to provide a cushion against future price increases. By depositing exactly $600 in this example, any stock price increase will technically put you back in a maintenance call so it is usually advisable to deposit something more than the amount required.

At any time, you are free to close out the short stock position and take the resulting profits or losses. Technically, there is no time limit for which you must return the shares. The only event that may force you to close the position early is if your equity is below the house percent and you do not meet the maintenance call. In that case, the broker may close out the position for you.

This is only meant to cover the basics of short selling and should not be considered a complete course. As always, you should contact your broker with specific questions regarding their house rules, minimum equity requirements, and maintenance call policies. Short selling is not for everyone as it entails significant risks. But if you balance your risks and rewards and use stop orders or other disciplined approaches for closing out the positions, you may find short positions to be a valuable asset.

Final Thoughts

Now that you understand short selling, the advantages of put options should be more apparent. If you buy a put, you are effectively shorting shares of stock. However, because you purchased the put, you only have a limited risk. Further, you do not need an uptick to purchase a put and do not need to meet the Reg T requirement. Every advantage that the stock market offers can be capitalized in a more effective and safer way using options.