The Finance Professor

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How Short Selling Works

10/08/07 - 08:14 PM EDT

Scott Rothbort

Short selling is often looked at as a nefarious aspect of trading and investing. However, it is quite legal, serves a necessary function in the securities security markets and can be a valuable tool for an investor -- whether on an individual or professional money-manager level.

Short selling provides investors with the ability to profit from the decline in a stock's price, hedge positions or portfolios, manage taxes and create arbitrage arbitrage positions. Since short selling is complex and operates outside of the sight of many investors, short selling is highly misunderstood. So in this installment of The Finance Professor, I will offer a primer on short selling by covering the mechanics behind the short selling process, the account brokerage-account requirements and the federal regulations that govern the transaction.

What Is Short Selling?

Short selling in its most basic form is when an investor takes a stance that a security will decline in value market-value. In doing so, the short seller will sell stock that they do not own. This transaction will trigger a series of processes that ensure that the sale of this stock can take place. I have created the following chart to help walk us through what happens.

Click here for larger image.

Every short sale can involve up to four different parties -- beyond that of clearing organizations clearing-firm, such as depositories and banks, which may also have a role in the transaction. Here are the functions that each player has in the process:

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At the time of publication, Rothbort had no positions, although positions can change at any time.

Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele.

Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.


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