Trading in Financial Markets
5.3 Long and Short Positions in Assets
The simplest type of trade is the purchase of an asset for cash or the sale of an asset that is owned for cash. Examples of such trades are:
The purchase of 100 IBM shares
The sale of 1 million British pounds for U.S. dollars The purchase of 1,000 ounces of gold
The sale of $1 million worth of bonds issued by General Motors
The first of these trades would typically be done on an exchange; the other three would be done in the over‐the‐counter market. The trades are
sometimes referred to as spot trades because they lead to almost immediate (on the spot) delivery of the asset.
When purchasing an asset through a broker, a trader can often borrow up to half the cost of the asset from the broker, pledging the asset as collateral.
This is known as buying on margin. The broker's risk is that the price of the asset will decline sharply. Accordingly, the broker monitors the margin account balance. This is the part of the purchase price paid by the investor adjusted for gains or losses on the asset. If the balance in the margin
account falls below 25% of the value of the asset, the trader is required to bring the balance back up to that level. Suppose a trader buys 1,000 shares at $120 per share on margin. The trader will have to provide half the cost or
$60,000. If the share price falls to $78, there is a $42,000 loss and the balance in the margin account becomes $18,000. This is 18,000/78,000 or 23.1% of the value of the asset, and the trader will have to provide $1,500 of cash to bring the balance in the margin account up to 25% of $78,000. If the trader fails to do this, the broker sells the position.
5.3.1 Short Sales
In some markets, it is possible to sell an asset that you do not own with the intention of buying it back later. This is referred to as shorting the asset. We will illustrate how it works by considering the shorting of shares of a stock.
Suppose an investor instructs a broker to short 500 shares of a certain stock.
The broker will carry out the instructions by borrowing the shares from another client and selling them on an exchange in the usual way. (A small fee may be charged for the borrowed shares.) The investor can maintain the short position for as long as desired, provided there are always shares
available for the broker to borrow. At some stage, however, the investor will close out the position by purchasing 500 shares. These are then replaced in the account of the client from whom the shares were borrowed. The
investor takes a profit if the stock price has declined and a loss if it has risen. If, at any time while the contract is open, the broker runs out of shares to borrow, the investor is short‐squeezed and is forced to close out the
position immediately, even if not ready to do so.
An investor with a short position must pay to the broker any income, such as dividends or interest, that would normally be received on the asset that has been shorted. The broker will transfer this to the client account from which the asset was borrowed. Suppose a trader shorts 500 shares in April when the price per share is $120 and closes out the position by buying them back in July when the price per share is $100. Suppose further that a
dividend of $1 per share is paid in May. The investor receives 500 × $120 =
$60, 000 in April when the short position is initiated. The dividend leads to a payment by the investor of 500 × $1 = $500 in May. The investor also pays 500 × $100 = $50, 000 for shares when the position is closed out in July. The net gain is, therefore,
Table 5.1 illustrates this example and shows that (assuming no fee is
charged for borrowing the shares) the cash flows from the short sale are the mirror image of the cash flows from purchasing the shares in April and selling them in July.
Table 5.1 Cash Flows from Short Sale and Purchase of Shares Purchase of Shares
April:Purchase 500 shares for $120 −$60,000
May:Receive dividend +$500
July:Sell 500 shares for $100 per share +$50,000 Net Profit = –$9,500
Short Sale of Shares
April:Borrow 500 shares and sell them for $120 +$60,000
May:Pay dividend −$500
July:Buy 500 shares for $100 per share −$50,000 Replace borrowed shares to close short position
Net Profit = +$9,500
An investor entering into a short position has potential future liabilities and is therefore required to post margin. The margin is typically 150% of the value of the shares shorted. The proceeds of the sale typically form part of the margin account, so an extra 50% of the value of the shares must be provided.
Suppose that 100 shares are shorted at $60. The margin required is 150% of the value of the shares or $9,000. The proceeds of the sale provide $6,000, so the trader must provide an extra $3,000. Suppose that a maintenance margin of 125% is set, so that when the balance in the margin account falls below 125% of the value of the shares there is a margin call requiring that the balance be brought up to this level. If the share price rises to $80, 125%
of the value of the shares shorted is $10,000, and an extra $1,000 of margin
would be required. The short trader must provide this to avoid having the short position closed out.
From time to time, regulations are changed on short selling. The SEC
abolished the uptick rule in the United States in July 2007 and reintroduced it in April 2009. (The effect of this rule is to allow shorting only when the most recent movement in the price of the stock is an increase.) On
September 19, 2008, in an attempt to halt the slide in bank stock prices, the SEC imposed a temporary ban on the short selling of 799 financial
companies. This was similar to a ban imposed by the UK Financial Services Authority (FSA) the day before.