The Hustler's Digest StaffShort selling may appear simple, but this type of speculative trading is fraught with danger. Here’s a closer look at how it works—and what you should think about before doing it.
Short-selling a stock can be advantageous if the stock’s price falls. Traditional investing entails purchasing a stock with the intention of later selling it for a more significant profit. Short-selling is selling stock now and then trying to repurchase it at a lower price later.
What is shorting the stocks?
Many successful traders profit from rising stock prices. However, some people use a tactic known as short selling to benefit from stocks losing value. Borrowing security and selling it on the open market is short selling. After repaying the first loan, you buy it at a cheaper price and pocket the difference.
Let’s say a stock is currently trading at $50 per share. You take out a $5,000 loan and sell 100 shares. When the price drops to $25 per share, you buy 100 shares to replace the ones you borrowed, making a profit of $2,500 in the process.
Why short stocks?
Shorting is motivated by two key factors:
To speculate
The most obvious motivation to short a stock or market is to profit from an expensive asset. The most famous example of this occurred in 1992 when George Soros “broke the Bank of England.” He bet $10 billion on the British pound falling, and he was correct. Soros made $1 billion from the trade the next night. His earnings eventually amounted to over $2 billion.
To make a hedge
Few competent money managers short an active investing strategy for reasons we’ll cover later (unlike Soros). The majority of investors use shorts to hedge their positions. This suggests they’re offsetting short holdings to protect other long positions.
How to start?
You must first open a margin account to hold qualified bonds, cash, mutual funds, and stocks as collateral because you’re borrowing shares from a brokerage business. You’ll be charged interest on the outstanding shares’ value until they’re returned, just like other types of borrowing (though the claim may be tax-deductible).
You can begin researching potential short-sale candidates once you’ve opened and financed your margin account. To find short-sale targets, traders often employ one or more of the following methods:
- Fundamental analysis: Analyzing a company’s financials might help you determine if its stock is due for a correction. For example, a company’s profits per share (EPS) and sales growth tend to move in the same direction as its stock price; as a result, traders may evaluate companies with negative EPS and sales growth trajectories while looking for short-sale possibilities.
- Technical analysis: Patterns in a stock’s price movement can also indicate whether it’s about to enter a decline. A stock going through a succession of lower lows while trading at increasing volumes could predict a seller’s market. Another example is a stock that has risen to the top of its trading range but appears to be losing steam.
- Thematic: This strategy entails betting against companies with obsolete business strategies or technologies (think Blockbuster Video), which can be a long game but can pay off if your prediction is accurate.
Entering a trade
Before you start trading, you should determine your entry and exit points and a possible stop order (see “A simple plan” below). If the deal goes against you, you’ll want to place a stop order to limit your losses.
In general, two kinds of stop orders may be helpful:
- If the stock price increases to or above the stop price, buy-stop orders trigger an order to buy back the shares.
- Trailing buy-stops define a stop price that “tails” the stock’s lowest price by a percentage or dollar amount you designate. If the stock increases by the trail or over its lowest price, a buy market order is triggered, and the stock is purchased at the best available price. The stop is reset at a lower price if the price falls.
However, neither of these methods guarantees that the order will execute at or near the price you designate, and in fact, the stop order could lock in losses if the price gaps up.
What is short selling?
Short selling is a trading or investment strategy that bets on the price of a stock or other security falling. This is a sophisticated approach that seasoned traders and investors should only use.
Traders can use short selling as a form of speculation. Investors or portfolio managers can also use it to hedge against the downside risk of a long position in the same or similar security. Speculation is a sophisticated trading approach that bears a high risk of loss. Hedging, or taking an offsetting place to reduce risk exposure, is more common.
A position is opened in short selling by borrowing shares of a stock or other asset that the investor believes will depreciate. The investor then sells these borrowed shares to market-rate bidders. The trader is betting that the price of the borrowed shares will continue to fall before they must be returned, allowing them to purchase them at a reduced price. Because the cost of any asset might rise to infinity, the risk of loss on a short sale is theoretically endless.
Example of short selling
When the company reports its annual earnings in a week, an investor believes Stock A, which is currently selling at $100 per share, will fall. As a result, the investor borrows 100 shares from a broker, and short sells them to the market. As a result, the investor has “shorted” 100 shares of Stock A that he does not own in the hopes that the stock’s price will fall.
After the corporation releases yearly earnings, Stock A’s price drops to $90 per share a week later. The investor decides to settle the short position by purchasing 100 shares of Stock A on the open market for $90 each and returning them to the broker; this is a buy-to-cover order. As a result, the investor earns a profit of $10 per share, or $1,000 total for the transaction, excluding commissions and interest.
If the stock price rises to $110 per share and the investor wishes to close the short position, he will have to buy-to-cover the 100 shares on the open market for $110 per share. Because the stock shares were acquired back at a higher price, the short sale transaction will result in a $10 per share or a total loss of $1000 (excluding commissions and interest).
Restrictions
There are numerous limitations on the quantity, price, and types of equities you can short sell. For example, you can’t short sell penny stocks, and most short sells must be done in round quantities.
Short selling also necessitates the use of margin. Like with a margin purchase (long) transaction, the proportion necessary varies depending on the eligibility of specific securities.
The short-selling margin requirements for Desjardins Online Brokerage can be found here. It’s worth noting that the percentages stated include proceeds from the short sale; thus, 150 percent reflects 100 percent of the short sale proceeds plus 50% of account margin.
Understanding the risks
Short selling comes with numerous risks, but these are the big two:
- Potentially limitless losses: Your risk is restricted to 100% of your initial investment when you place a conventional transaction. However, when you short a stock, the price can continue to rise, implying that the amount you’d have to pay to replace the borrowed shares is theoretically endless.
For example, you initiate a short position on stock XYZ at $80, but it rises to $100 instead of sinking. To repay your borrowed shares, you’ll have to spend $10,000, resulting in a $2,000 loss. Stop orders can assist in reducing this risk, but they aren’t foolproof.
2. Margin calls: If the value of the collateral in your margin account falls below the minimum equity requirement—usually 30 percent to 35 percent of the value of the borrowed shares, depending on the firm and the securities you own—your brokerage may require you to deposit more cash or securities to make up the difference right away.
For example, assuming a 30% equity requirement ($8,000 x.30), you’ll need $2,400 in your margin account if your 100 shares of stock XYZ continue at $80 per share. If the stock suddenly jumps to $100 a share, you’ll require $3,000 ($10,000 x.30), necessitating a $600 infusion into your account, which you may or may not have.
If you fail to meet the margin call, your brokerage firm may close out open positions to bring your account back to the minimum requirement.
Additional considerations with short selling
Besides the previously-mentioned risk of losing money on a trade from a stock’s price rising, short selling has additional risks that investors should consider.
Shorting uses borrowed money
Margin trading is another term for shorting. When short selling, you open a margin account with the brokerage business, which allows you to borrow money using your investment as collateral. Because you must fulfill the minimum maintenance requirement of 25% when you go long on margin, it’s easy for losses to grow out of hand. If your account falls below this level, you’ll face a margin call and be compelled to either put more money in or liquidate your stake.
Wrong timing
Even if a firm is overvalued, it could take a long time for its stock price to fall. You’re still exposed to interest, margin calls, and getting called away in the meantime.
The short squeeze
A short squeeze is possible when a stock is aggressively shorted with a high short float and days to cover ratio. When a stock begins to climb, short-sellers cover their trades by buying back their short positions, resulting in a short squeeze. This purchasing might become a feedback loop. Demand for the stock draws in additional purchasers, pushing the stock higher and prompting more short-sellers to buy back or cover their bets.
Regulatory risks
To avert panic and unjustified selling pressure, regulators may implement short-sale bans in a single sector or even market. Such efforts can result in a sharp increase in stock prices, causing the short seller to cover their short positions at a significant loss.
Going against the trend
Stocks have a long-term increasing trend, according to history. The majority of stocks increase in value over time. Even if a company improves marginally over time, inflation or the pace of price increase in the economy should cause its stock price to rise. This indicates that shorting is betting against the market’s general direction.
Costs of short selling
Short selling, in contrast to buying and retaining stocks or assets, incurs hefty charges in addition to the standard trading commissions that must be paid to brokers. The following are some of the costs:
Margin interest
When trading stocks on margin, margin interest can be a considerable cost. Because short sales may only be executed through margin accounts, the interest paid on short trades can quickly pile up, primarily if they are held open for a lengthy period.
Stock borrowing costs
Shares that are difficult to borrow—due to high short interest rates, restricted float, or other factors—have “hard-to-borrow” fees that can be pretty expensive. The price is proportional to the number of days the short trade is open and is based on an annualized rate that can range from a fraction of a percent to more than 100 percent of the value of the short trade.
The exact dollar amount of the fee may not be known in advance because the hard-to-borrow rate can fluctuate significantly from day to day, even on an intra-day basis. The broker-dealer usually applies the fee to the client’s account at the end of the month or when the short transaction is closed. It can significantly reduce the profitability of a short trade or compound losses on it if it is significant.
Dividends and other payments
The short seller is liable for paying the shorted stock’s dividends to the company from which the shares were borrowed. Other events related to the shorted stock, such as share splits, spin-offs, and bonus share issues, all of which are unpredictable, are also the responsibility of the short seller.
Short selling metrics
Two metrics used to track the short-selling activity on a stock are:
- Short interest ratio (SIR)—also known as the short float—the dividends on the shorted stock must be paid to the business from whom the shares were borrowed by the short seller. Other unforeseeable events involving the shorted stock, such as share splits, spin-offs, and bonus share issues, are also the responsibility of the short seller.
- The short interest to volume ratio—also known as the days to cover ratio—is the total number of shares held short divided by the stock’s average daily trading volume. A high day to cover ratio is also considered a bearish indicator for a stock.
Both short-selling indicators aid investors in determining whether a stock’s overall sentiment is bullish or bearish.
For example, General Electric Co.’s (GE) energy businesses began to drag on the company’s performance after oil prices fell in 2014. Short-sellers began predicting a stock collapse in late 2015, and the short-interest ratio rose from less than 1% to more than 3.5 percent. By the middle of 2016, GE’s stock had reached a high of $33 per share and was starting to fall. By February 2019, GE had dropped to $10 per share, resulting in a $23 per share profit for any short-sellers who had been lucky enough to short the stock around the top in July 2016.
Ideal conditions for short selling
When it comes to short selling, timing is everything. A significant gain in a company can be wiped out in days or weeks due to an earnings miss or other unfavorable news. As a result, the short seller must time their short trade to near perfection. Because a large portion of the stock’s slide may have already occurred, entering the trade too late may result in a significant opportunity cost for lost gains.
Entering the trade too early, on the other hand, may make it difficult to maintain the short position due to the fees and potential losses, which could explode if the stock rises swiftly.
There are moments when your chances of succeeding at shorting improve, such as when:
During a bear market
During a bear market, the primary tendency for a stock market or sector is down. Traders who believe “the trend is your friend” have a better chance of making lucrative short sell bets in a deep bear market than in a strong bull market. Short sellers thrive in rapidly depreciating, broadening, and deepening markets, such as the global bear market of 2008-09, because they stand to earn handsomely.
When stock or market fundamentals are deteriorating
The fundamentals of a company can deteriorate for various reasons, including slower revenue or profit growth, increased business problems, growing input costs that put pressure on margins, and so on. Worsening fundamentals for the overall market might entail a string of weaker data points pointing to a likely economic slowdown, adverse geopolitical developments such as the danger of war, or bearish technical signs such as new highs on lower volume and declining market breadth.
Short-sellers with experience may prefer to wait until the negative trend is verified before entering short transactions rather than anticipating a downward move. This is due to the possibility that, in the final phases of a bull market, a company or market may move higher for weeks or months despite worsening fundamentals.
Technical indicators confirm the bearish trend
When many technical indicators confirm a negative trend, short sales may have a better chance of succeeding. These indications are examples of a collapse below a critical long-term support level or a bearish moving average crossover, such as the “death cross,” are examples of these indications. When a stock’s 50-day moving average goes below its 200-day moving average, this is an example of a bearish moving average crossover. A moving average is simply the average price of a stock over a given period. If the current price falls below or rises above the norm, it may indicate a new price trend.
Valuations reach elevated levels amid rampant optimism
Occasionally, values for specific sectors or the market might skyrocket due to widespread optimism about the long-term prospects of those industries or the overall economy. This stage of the investment cycle is known as “priced for perfection” since investors will undoubtedly be disappointed when their lofty expectations are not satisfied. Experienced short-sellers may wait until the market or sector rolls over and begins its downward phase before entering on the short side.
Short-selling controversy
Short-sellers are subjected to a barrage of criticism. They’ve been accused of causing corporate damage, public opinion manipulation, and spreading rumors about a firm or stock. Short-sellers have even been accused of being unpatriotic for not supporting publicly traded corporations.
On the other hand, short-sellers frequently offer new information to the market, leading to a more realistic evaluation of a company’s prospects. This can result in a stock remaining at a lower price than if only cheerleaders were there. The shorts help keep exuberant enthusiasm in check, and they frequently expose fraud, aggressive accounting, or poorly run businesses, information that could be hidden in a company’s SEC filings. In the capital markets, these are all valuable functions.
How does shorting a stock work?
Shorting is a tricky business. Short-sellers start a trade by borrowing shares of a stock they believe will lose value. They then sell those borrowed shares to investors who are willing to pay their current market prices. The short-seller will eventually have to return the shares they borrowed, but first, they must repurchase them.
Short-sellers bet on the stock’s price dropping. They aim to pay a lower price than what they sold the shares for when they repurchase them to return them to the broker they borrowed them from.
Short-sellers increase the number of sellers (those who want to sell) versus purchasers, putting pressure on stock to sell (those who wish to buy). Because the price of a stock is determined by how many people want to sell vs. buy it when many shares are sold short, the price of the stock drops.
On the other hand, short-selling ensures a volume of future buying equal to the number of shares sold short. Short interest is a measure that shows how many borrowed shares are currently in circulation. If a stock has no short interest, no forced buyers will be forced to acquire it in the future. If a stock has a Short Interest of 1,000,000 shares, however, it will be required to buy 1,000,000 shares at some point in the future.
A short position can be kept for an unlimited amount of time. All that is required is that brokers continue to permit the leasing of shares. On the other hand, Short-Selling does come with a borrowing (or financing) fee. When a stock is borrowed for short-selling, the Short-Seller must pay the stock’s owner an annual percentage charge. Stocks with many short interests usually have a high borrowing cost due to the high demand for borrowing shares. Stocks with a lower fast interest rate have a lesser tendency to borrow.
Can retail investors short a stock?
Shorting a stock is an option for retail investors, and some hedge funds advertise themselves as long/short, with heavy short positions. If ordinary investors want to short a stock, they’ll need to use an online brokerage that lets them borrow shares.
Is shorting a stock legal?
In most stock markets, shorting a stock is permitted most of the time. Yet, depending on the market situation, the Securities and Exchange Commission and other regulators may temporarily prohibit short sales of particular stocks. During the 2008 Global Banking Crisis, the SEC, for example, prohibited short sales of around 800 financial stocks. While short selling is lawful, spreading misleading information to cause a stock’s price to fall is not.
What if the stock price rises?
The most you can lose in a standard stock purchase is the amount you paid for the shares, but the upside potential is virtually limitless. When you short a stock, your gains are capped at the total value of the shorted shares if it goes to zero, but your losses are theoretically unlimited because the stock price can climb indefinitely.
Let’s have a look at the same scenario as before. You borrow ten shares and sell them for $10 each, making a profit of $100. The stock then surged to $50 per share. Remember that you’ll have to return the shares to the broker at some point, which means you’ll have to repurchase them for $500 – a $400 loss. If the stock rises to $100 a share, you’ll have to repurchase it for $1,000, a $900 loss. This can theoretically continue indefinitely, and the longer you wait for the stock price to drop, the more interest you’ll pay on the borrowed shares.
If this happens, a short-seller may receive a “margin call,” forcing them to either put up more collateral in the account or close the position by purchasing the stock.
Given the market’s long-term upward trend, many investors find it challenging to consistently generate profits by shorting equities. Furthermore, the danger is significantly more significant than a buy-and-hold approach, especially if you don’t know what you’re doing.
The bottom line
At its most basic level, short selling entails betting against individual companies or the market, and some investors may object to principle. Shorting can be a rewarding strategy to act on your instincts if you believe that stock price or index is headed lower—as long as you’re aware of the hazards.
