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Most stock market investors make money by anticipating stock prices. They buy a stock when they believe that the price of the stock will rise over time and whenever it does, they will sell it for a profit. This is a simple and common way of stock trading. It is known as going long or taking a long position. However, stocks do not always have to go up for investors to make money off them. One can also profit if the stock's price falls, and it is known as short sell.
Investors often use this strategy as a form of speculation. It is a high-risk strategy that could also yield high returns in exchange. While a long-term investor would base the decision on a complete examination of the fundamentals of the company, future potential, and management, a speculator will base the decision on the analysis of the short-term price movements in the hope to make big profits. Here’s a complete guide on short selling.
Related: How to Borrow a Stock to Short Sell
In this article
What is short selling?
The practice of short selling is when a trader borrows shares from the broker and sells them instantly with the hope that the price will fall shortly after. When the price of a stock falls, the trader can purchase the shares back at a lower price and return them to the brokerage while keeping the difference as a profit. It is important to remember that the shares are not owned but borrowed.
For example, you borrow 10 shares of a company and sell them for $15 each, generating $150. Now, when the price of the shares dips to $10 per share, you can use the $150 to buy back all the shares for only $100 and return the shares to the broker. This will leave you with a profit of $50 on the short.
It may sound simple but there is a lot that goes into the process of short-selling stocks and the strategy also carries the risk of unlimited losses. Many times, investors are convinced that the stock will fall in value more than rise and this is when they make money once the stock goes down. It is also known as shorting a stock and is a trading strategy that gives you a profit in case the share price of the stock falls. And if it rises, you could lose money.
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Why do investors short a stock?
You can decide to short a stock because you think it is overvalued and the price may decline in the near future. The shorting process involves borrowing the stocks you do not own and selling them. When the price drops, you buy back the shares with less money than you originally received when you sold them.
There are situations when shorting the stock can be useful. This is when you own a stock of a specific industry but you want to hedge it against an industry-wide risk, then shorting the stock in the same industry will help protect against losses. There is a benefit of shorting from the tax perspective. When you short a stock instead of selling the holdings, it will benefit you in terms of tax liability.
How to short a stock
Here are the steps you must follow to short a stock.
You will need a margin account because borrowing shares from the brokerage is a margin loan, and you will pay interest on the debt. Hence, open a margin account with an online brokerage. You may need to be approved for it.
- In order to make a short trade, you need stock equity or cash in the margin trading account which will work as collateral. This amount must be at least 50% of the short position’s value. Once you meet this requirement, you can enter a short sell order in the brokerage account. But you will not be able to liquidate the cash you receive from the short sale, which is one thing you must always keep in mind. Decide the number of shares you want to short and then proceed.
- Now if you want to maintain the short position, you need enough equity in the account which will serve as collateral for the margin loan. As per the exchange rules, you need at least 25% equity. Different brokerages may have a higher minimum requirement based on the risk associated with the stock and the total value of the investor’s position.
- It is possible to maintain the short position as long as you want to. It can be a few hours or a couple of weeks. But you need to remember that you are paying interest on the shares you borrowed and will also have to maintain the margin requirement throughout this period.
- In case the price of the stock falls, you can close the short position by purchasing the amount of borrowed shares at a lower price and then returning them to the brokerage. To earn a profit, you need to consider the amount you will have to pay in fees, commission, and interest. In case the price of the stock rises, it will cost you more to buy back the shares, and you will need extra money for it.
The risks of shorting a stock
A major risk involved with short selling is that if the stock price rises, it will become difficult to cover the losses. Shorting can produce many losses because there is no upper limit to how high the stock price can go. However, the broker will not require you to have an unlimited supply of cash to handle the potential losses, but if you lose a high amount of money, your broker will invoke a margin call. This means you must close the short position and buy back the shares at a higher price.
Sometimes, short sellers have to deal with another situation that forces them to close their positions without notice. When a particular stock is a popular target of short-sellers, it could become difficult to locate the shares to borrow, and if the shareholders who have lent you shares want them back, you will have to cover the short. This means the broker will force you to repurchase the shares before you are willing to.
Price rise
When you make a traditional stock purchase, the most you lose is the amount you paid for them. However, there is immense upside potential. But in shorting a stock, it is the opposite. Your gains will be maxed out at the total value of the shorted stock when it falls to $0 but the chances of losses are limitless as the price can rise indefinitely.
The longer you wait for the stock to fall, the longer you will pay interest on the shares you have borrowed. You may also have to put up more collateral in the account to maintain the position or close it by purchasing the stock at a higher rate. Considering the long-term upward bias, there are many investors who find it difficult to short stocks and achieve consistent returns. If you are unsure or experienced in what you are doing, the risk is very high. If you borrow 10 shares and sell them for $15, you make $150 instantly, but if the shares reach $30, you are on the hook for returning them since they are borrowed. Now, you will have to buy the shares for $30 and pay $300 -- a loss of $150. If they soar higher, you have to pay more.
Short Squeeze
When the stock is heavily shorted, there is a risk of experiencing a short squeeze. It happens when the stock rises, and the short sellers cover the trades by buying the short positions back. It could turn into a reverse loop. The demand will attract more buyers, and that will push the stock higher, causing more short sellers to buy back the positions.
Regulatory Risks
There are times when the regulators impose bans on short sales in a certain sector to avoid the panic selling pressure. It can also cause a spike in the stock prices and could force the short seller to cover the short position despite making losses.
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Costs associated with short selling
Short selling comes with significant costs. In addition to the trading commissions, there are other costs to be paid to the brokers, and you must keep them in mind when entering a trade.
Margin Interest
When trading stocks on the margin, the margin interest is a big expense. You can only make short sales through margin accounts, and the interest payable on the trades will add up over time in case you keep the short position open for an extended period.
Borrowing costs
The shares that are difficult to borrow due to the high short interest attract high borrowing costs and this cost can be quite substantial. It is based on the annualized rate that can range from a small percent to more than 100% of the value of the trade, and it is tied to the number of days the trade is open. Since this rate fluctuates from day to day and even on an intraday basis, it is impossible to know the right amount of fee in advance. If it is large, it could make a huge dent in the profitability of the trade.
Dividend payments
In case of a dividend, the short seller will be responsible for making the payment on the shorted stock to the entity from whom the stock is borrowed. He is also responsible for making payments on the other events associated with the stock, including bonus share issues and share splits.
Pros and cons of shorting
Pros
- Potential to make huge profits
- Small investment required
- Enables hedging
- Tax-efficient
Cons
- Possibility of losing all your money
- Margin interest can be high
- Short squeezes
When should you short a stock?
A short-selling opportunity will occur whenever assets become overvalued. Since financial securities trade regularly, they are also affected by the volatility in the stock market, and this is why they can become overvalued or undervalued at times. The key to shorting is to identify the securities that could be overvalued when they may decline or the price they would reach.
Assets will stay overvalued for a long period of time, but longer than a short seller can stay solvent. If you assume that companies in the tech sector will face industry headwinds four months from now and buy stocks that are short-sale candidates, it could still take longer for the companies to begin to reflect on the problems. You may have to wait before you establish a short position. It is possible to enter or exit the short sale on the same day or remain in the position for many days or weeks.
The timing is crucial to short selling and its impact on taxation. It will require attention and experience. You can consider placing limit orders, trading orders, or trailing stops on the sale to limit the risk exposure or lock in profits at a certain level. The bear market is also a good time to short-sell stocks. This is when the market or sector is down, and you believe the trend will continue. You can make high profits during this time.
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The bottom line
You must think of shorting as a tool in your strategy that calls for identifying the winners and losers in a sector or industry. It is possible to go long on a company and short on another company in the same industry. You can use shorting to hedge funds in your existing long position. Let us assume you own the shares of ABC company and expect them to weaken in the coming months but do not want to sell the stock. Hence, you can hedge the long position by shorting ABC company since you expect it to weaken and then close out on the short position when the stock is expected to gain.
Shorting a stock is simple but not suitable for beginners or inexperienced traders. You should consider shorting if you are a professional, practiced investor and know the implications. However, it is not something that works for all. It is important to remember that the SEC restricts who can sell short, which securities can be shorted, and how they can be sold. The Securities and Exchange Commission also has limitations to shorting low-priced stocks.
Additionally, there could be restrictions to prevent panic selling. Another restriction is the uptick rule. It is designed to stop short-selling from further reducing the stock price that has already dropped more than 10% in a single trading day. If you want to short a stock, you must know the different types of limitations that can impact your strategy.
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Editor
Vandita Jadeja is a financial writer and editor at Joywallet. She loves to read and write about money and brings a decade of experience from the financial industry.
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