Short Sale Requirements & Strategies

Instructor: Yusuf Abdullah

Yusuf has taught Science and Mathematics at school level and Finance and Economics at University level. He has recently earned his Ph.D in Financial Econometrics.

In this lesson, we explore short sale requirements and strategies. You'll learn about order marking, margin requirements, investor types, FINRA Rule 4320, SEC Regulation SHO and other aspects of short sales.

What Is a Short Sale?

Mark is a technology buff and has been a freelance beta tester for a long time now. He has recently registered to test an upcoming game of a major game company. Mark found a number of bugs in the game and thinks that the company's image will be harmed when the game is released. He has approached Joey, a friend who works at an investment firm. Mark wants to sell his stocks of this company to prevent a loss in the future. He laments that he does not have any more investment options left. Joey recommends that if he is so confident, he can short the stocks of this company in order to earn profits.

Joey explains that a short sale is a strategy by which an investor borrows stocks of the company and sells them. The investor is anticipating a price decline in the future and would benefit by selling at a higher price. The share would be bought at a lower price in the future and returned to the person or entity from which it was borrowed.

Short Sale Strategies

Mark is not sure how to approach a short sale, so Joey recommends three short sale strategies:

Selling From Pullback in Downtrend

A pullback is a small reversal in an otherwise long downward declining trend for the stock. This usually happens when a declining stock is provided support by people trying to buy at a lower cost. A short sale at this moment would yield a profit if the downward trend continues.

Support Breakout Trading

Stocks usually trade within a given range but internal or external factors may result in the movement out of the given range. When the factors lead to a decline below the given range, i.e. breaking the support level, a short sale is profitable.

Active Decline

When the stock is in a freefall and the investor anticipates that the fall will continue in the future, short selling can be highly beneficial. This strategy would yield the highest profits as there is no support level.

Investor Types

Mark asks if the previously mentioned strategies would differ due to the market conditions as well as due to the type of investor and the type of their current holdings. Joey explains that short sale strategies differ and the investors can be broadly classified as:

  • Speculators: A speculator has some reason to believe that the stock would fall in price and hence they take the short sale to profit. They do not own the shares initially. Mark is a partial speculator because he wants to make a profit over selling up his shares.
  • Hedgers : Hedgers take a position against their current holdings. A hedger would make a short sale if his stock holding is to decline. Hedging using a short sale would happen for similar securities but not the same. Mark cannot be hedger because he is already selling the stocks he owns.
  • Arbitrageur: An arbitrageur has some knowledge about the price of the security in the future and takes action likewise to earn a profit. Mark is arbitrageur because he has information regarding game and stock.

Regulation SHO

Mark understands the strategies to some extent but is worried that these strategies may lead to a significant loss. There is also a risk that the stocks may not be available to return to the lender. Joey calms his fears by explaining the SEC Regulation SHO, which includes the following points:

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