U of Finance

Many Hedge Funds, Mutual Funds, and Investors partake in Short Selling for many reasons.

: Diversification and 'hedging'

: Flexibility to implement their ideas in the markets

An in depth explanation of short selling

Step 1: Short selling is the process of borrowing a stock from somebody who will lend you the stock they own. Typically a hedge fund manager must go through their prime brokerage who will then find somebody who will lend you the shares you need. You must first deposit cash into the margin account as a down payment. This is determined by the prime brokerage as a percentage of the total you want to borrow in case the manager does not pay the lender back. Additionally there is a borrowing fee that the lender of the shares will charge.

: Typically the initial deposit in a margin account, set by Regulation T, is 50% of your total planned purchases and 5% for government bonds. Thus if you plan on shorting $25,000 worth of shares you must put $12,500 into the account as cash and the brokerage will lend you the $25,000 value of the shares to allow you to move to step 2. Theoretically, if the manager backs out of the short sale, the prime brokerage can just sell the $25,000 worth of shares and return them to the lender and return the $12,500 to the manager. The next tab explains the initial deposit and margin requirements much more in depth

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Step 2: The Hedge Fund manager will then sell the borrowed shares on the open market, collecting the proceeds from the sale. This money goes into the margin account in addition to the cash that was deposited when the manager first borrowed the shares to serve as additional collateral. All the while the initial deposit and proceeds are in the account, they are typically earning a short term interest rate which of course is beneficial to the Hedge Fund manager

Margin Account (Assets)

Liabilities



% Collateralized



$12,500 initial deposit

$25,000 sold



$25,000



150%



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Step 3: When the manager determines the time is right, thus the price of the shares have declined, the manager will then buy back the same number of shares he borrowed at a lower price and return the shares to the lender and collect the difference between what the manager sold the shares at and what he bought them back for. This is called cover the short.

: On the contrary, if the shares rise in the market, the manager has two options.

1. He can buy the shares back and return them to the lender at a lower price

2. The prime brokerage, who determines the percentage collateral that is in the margin account, may make a margin call where the brokerage states that more money needs to be deposited in the brokerage account or else the brokerage forces you to cover your short and return the shares to the lender.

: Note- In the case the stock falls, the lender was long the stock while you were short, thus the lender of the shares will receive the number of shares they lent in the first place, but at a lower price. You won, he lost. Simple as that.