Selling short is an advanced trading strategy that investors use when speculating whether the price of a stock will go down. Here’s how it works: Investors borrow a stock and sell it, hoping to buy it back later at a lower price. It’s also a strategy that has made headlines in the past few months.
If you’ve kept up to date with the stock market news, you may have heard of short sellers who have lost millions of dollars in the face of soaring stock prices, such as AMC and GameStop Corp. Whether you are an investor yourself or are interested in learning more about investing, you are in the right place to find out what short selling is, including shorting stocks and the risks and benefits of short selling
Short sales explained
What does it mean to buy a stock short? Selling stocks short is an advanced trading strategy used to either hedge or speculate on the expected decline in the stock price. When the stock price goes down, it translates into a profit. If it goes up, it leads to a loss.
It is essentially the opposite of long position investing. Long-position investors own stocks that they bought at a lower price and hold on to the stocks in anticipation of prices rising in order to make a profit on selling the stock. In contrast, short position investors borrow the stocks from a broker and sell them at a higher price in the hopes that the stock price will fall so they can buy back them at a lower price and make a profit. However, short selling stocks theoretically carries an unlimited risk of loss because there is no upper price limit for a stock.
In order to be able to make short sales on the exchange, a trader must have a margin account, which is a type of brokerage account. Under this arrangement, the broker lends the investor cash to buy stocks, which comes with an interest rate. The margin account also has a regulated minimum value and if it falls below the maintenance margin the investor must either add more money to the account or sell their positions.
Why Sell Stocks Short?
Short selling of stocks is common in the stock market and is typically done by hedge funds and professional investors. Two of the main reasons for short selling stocks are speculation and hedging.
The majority of investors who sell short will do so to hedge the risk of owning shares, commonly referred to as a long stock. When the market falls, the short position protects the long position, and when the market rises, the long position protects the short position. For the hedge to work, both long and short positions must be highly correlated.
And a speculator is an investor who takes additional risks and the resulting profit. An example of short selling was in 1992 when George Soros risked a short position in the British pound for $ 10 billion and made an estimated $ 1 billion in just a few months.
How to sell short a stock
If you are wondering how to sell stocks short, keep in mind that this can be a high risk investment and should only be made by experienced investors and traders. Here is the process of shorting stocks in four steps:
- The first thing you need to know about selling short any stock is checking the margin requirements for the stock.
- After meeting the margin requirements, the broker borrows the shares, which comes with an interest rate on the outstanding debt.
- Once the stocks are borrowed, investors will sell stocks at the current market price in hopes that the price will go down.
- When stock prices go down, the investor then buys back those stocks at the lower price.
- Since the shares were borrowed, the short seller will then return those shares to the lender and keep the difference as profit.
Pros and Cons of Short Selling
By and large, short stocks seem simple. However, there are some advantages and disadvantages:
|Benefits of Short Selling||Disadvantages of short selling|
|Possible high profit||Unlimited damage potential|
|Protection for long positions||Margin interest rate|
|Lower portfolio volatility||Dealing with margin|
|Potential for long squeeze||Potential for a short squeeze|
The possibility of high profit is one of the reasons traders choose to buy short the stock market, in addition to being able to leverage their investment without having to have the money upfront. Another reason to go short is the ability to protect long positions with low initial capital and lower portfolio volatility.
However, selling stocks short comes with significant risks. Since the price of a stock can rise indefinitely, there is unlimited potential for loss and the possibility that this will lead short sellers to buy back their positions, leading to a possible short squeeze. Short selling stocks also requires the trader to have a margin account that comes with interest rates and minimum capital.
Additional Considerations for Shorted Stocks
Short selling stocks is a high-yielding but high-risk investment that requires trading experience. Therefore, there are some additional risks and costs associated with it.
Timing is important to being able to short a stock. Since stocks tend to fall faster than they rise, this can lead to high opportunity costs and capital losses. Also, if the overvalued stock takes a long time to decline, investors will have to pay interest longer.
Broker margin requirements are complex but necessary to protect market liquidity as a whole. The short selling margin starts with an initial margin of 150 percent of the share selling price. Since 100 percent of the sales proceeds can be applied to the margin, a balance of 50 percent is required to meet the initial margin.
While stocks can also be used to meet margin requirements, they are not all and the broker determines the margin value. After this initial margin, the short sale is also subject to the margin maintenance rules. However, an increase in stock prices could cause the account to drop below the minimum and result in a margin call. This would require additional cash or securities on deposit. Conversely, if the share price falls, funds can be withdrawn from the account or reinvested.
There are also some additional costs associated with selling short stocks. One of them is margin interest, which can accrue if the short positions are kept open for a longer period of time. Brokers charge interest on borrowing stocks. Each broker has a different interest rate for different loan amounts. Depending on the size of the loan, the current margin interest rates can be around 7 percent and are subject to interest rate increases and decreases.
Another common expense is when the investor sells a hard-to-borrow stock short, which comes with a higher fee. Finally, the short seller must also make dividend payments on the stocks sold short.
Increase in value
Stocks tend to appreciate over time, so short sellers are essentially trading against the stock trend. Even when the stock is overvalued due to inflation and other factors, prices tend to move upwards. This affects the chances of short sellers buying the borrowed stocks at a lower price for a profit.
A short squeeze occurs when the price of a stock begins to rise and short sellers decide to buy back their positions to avoid a major loss. This creates a snowball effect where prices skyrocket, causing more short sellers to cover their positions and buy back.
SEC uptick rule
The SEC reintroduced the alternate uptrend (Rule 201), which is designed to curb short selling of a stock that has fallen more than 10 percent in a single day. Short sales would only be permitted at this point in time if the price of the security was above the current national best bid.
Examples of short sales
It can be easier to understand short selling with examples:
Short Selling Example: Profit
ABC stock is currently trading for $ 10, and one trader believes its price will go down. The trader would go to a broker and borrow 10 stocks, which would cost $ 100. You sell those stocks right away, hoping the price will go down.
A month later, the stock price drops to $ 5 and the trader decides to close the short position and buy back the 10 shares for $ 50. Since they originally sold it for $ 100, the trader would then have made a profit of $ 50 on that short stock, excluding interest and commissions.
Short Selling Example: Loss
Let’s consider the same scenario where the trader borrowed 10 shares of ABC at $ 10 and sold them for $ 100. But this time the stock price rises to $ 30.
The trader decides to close his short position to avoid further losses should prices continue to rise. They would then buy 10 shares at the current price of $ 30, which cost them $ 300. In this example, the dealer would have lost $ 200 since they originally sold it for $ 100.
The bottom line
Learning how the stock market works can be a great way to understand potential investment opportunities. If you began by asking yourself, “What is short selling?” You should now have a good understanding of how experienced traders participate in this trading strategy, and the risks and benefits involved.
Frequently asked questions about short selling
Here are some common questions traders may have as they learn more about short selling:
Why do short sellers have to borrow stocks?
Short sellers must borrow stocks so that the stocks sold can be delivered to the buyer of the stocks on the other side of the short sale for a profit. Since you can’t sell a stock that doesn’t exist and companies have a limited number of stocks, the broker will need to borrow one that already exists.
Is Short Selling Illegal?
Short selling is a legal form of trading and is regulated by the US Securities and Exchange Commission. However, it is illegal to participate in naked short selling, which is the practice of selling short stocks whose existence has not been established.
Are Short Selling Bad?
Some traders believe that short selling could result in an unstable securities market and that short sellers know additional information that others do not. Others see it as a useful practice that could potentially help companies operate more efficiently.
Can shorts be sold through an individual account?
Some brokerage firms allow shorts to be sold on individual accounts as long as investors apply for a margin account.