One of the unique trading techniques used by traders, investors, and hedge fund managers is short-selling. Short selling is also known as shorting a stock or going short. Short selling can bring big returns when done the right way. It has always been a popular investment strategy for those with a high-risk tolerance.
Short selling stocks is a pretty simple concept. It is based on predicting that stock prices will go down rather than up.
Short-sellers usually borrow stocks from their broker, then sell those stocks at the current market price, which they believe is high. Then, when they believe the market price of those stocks has gone down enough, they will repurchase the stocks at a lower price to return them to their broker. Short-sellers then profit from the difference between the proceeds from the short sale and the cost of repurchasing the stocks. The assumption short-sellers make is that the price of the stocks they are buying will drop.
This practice is, at times, criticized, but it is completely legal. It is commonly used by traders who deal in currency, futures, or public securities. This guide explains how short selling stocks works, its advantages and limitations, and the risks involved.
What Is Short Selling Stocks?
The strategy to short a stock is used by speculators when they feel that a stock is overvalued. They believe that they can sell the stock today at a higher price and repurchase it later at a lower price. If this does happen, they earn a profit. Short sellers use this form of trading purely for speculative purposes. In contrast, investors and portfolio managers will use it to hedge or protect a long position’s downside risk in another security.
A key feature of short selling stocks is that it involves an unlimited potential risk against limited gains. Any financial instrument can grow infinitely as the underlying asset becomes more valuable. However, its value can only ever reach ‘Zero’ and not go below that. Since short selling stocks is a bet on a drop in the asset price, losing trades could wipe out an entire portfolio if not managed properly.
When successful, short selling stocks can give the investor a significant profit in a short time period. However, it has a high-risk-to-reward ratio because any stock price can rise quickly, and losses can mount infinitely. Nevertheless, traders and investors are attracted to this short sale concept due to the leverage of not owning the instrument to sell it.
Hedge fund managers use shorting of stocks to profit during a financial crisis or stock market decline. That’s because the fund can sell the stock when it’s high and buy when it’s low. This leverage can help generate substantial returns with just small movements in the underlying asset price. Still, the leverage again is a double-edged sword and can quickly wipe out small accounts.
How Short Selling Stocks Works?
Let us consider an example to understand how short selling stocks works. Imagine that you believe the price of ABC stock is overvalued, and it will crash very soon. This belief is so strong that you borrow 100 shares of this stock from a broker and sell them at $100 each, thereby generating $10,000.
So, you have $10,000, and 10 days later, the stock price drops to $75 per share. So, you decide to close your position by buying back 100 shares on the open market for $7,500 (100 X $75). This results in a profit of $2,500. You then happily return the borrowed shares to your broker.
However, if the share price increases and rises above $100 per share, you incur a loss because you will have to spend more money to repurchase those 100 shares to return them to the broker.
Let’s assume the share price increases to $125 per share and is expected to rise further. To limit your losses, you decide to close your position by buying back 100 shares for $12,500 (100 X $125). This results in a net loss of $2,500.
Please note that this example does not consider any costs associated with this short sale, such as interest and potential stock dividends.
Pros and Cons of Short Selling and Short Positions
Shorting a stock has its advantages and limitations. It is a risky endeavor and can easily result in massive losses if the stock’s price movement’s expectations are incorrect. There is no limit to the losses of a short-sale trading strategy. However, risky strategies often offer high rewards. Short selling can result in huge profits if the seller can predict the price increases and decreases correctly.
- High profits can be earned by speculation
- Possibility of leveraged investment
- No need for big initial capital
- Useful for hedging against other holdings
- Infinite potential losses
- Need for a margin account
- Margin interest is incurred (interest paid to the broker for the loan)
- Short squeezes (a short squeeze happens when short sellers trigger a price increase on a heavily shorted stock. Short-sellers close their positions because they expect the stock price to increase further, not decrease as they initially expected. The more short-sellers close their positions, the bigger the squeeze.)
If done right, short selling stocks can provide a cost-effective way to hedge and counterbalance other holdings. However, investors should gain some trading experience before getting involved in this strategy.
Risks of Short Selling Stocks
Limited gains, unlimited losses: Short selling stocks exposes investors to limited gains and unlimited losses. If the investor buys a stock at a certain price, the maximum he can lose is the amount he paid for it because the value of a stock does not drop below zero. However, a short sale has amplified risks because a stock’s price can keep rising to infinity, and the investor can lose an infinite amount of money.
Availability of the shorted stocks: Another risk is associated with the possible limited availability of the shorted stock for sale when it is time to close the position. This can happen when the stock is traded thinly, or other investors are also shorting this stock. It is also possible for the seller to get into a short squeeze loop if the stock or the market starts skyrocketing.
Timing: Wrong timing can also expose the trader to an increased risk of being vulnerable to margin payments and interest. It can take some time for a stock price to decline even when the stock is overvalued. Another danger comes from managing a margin account. When a trader borrows from a broker to short sell, the trader might incur big losses by having to pay a margin call. A margin account requires a trader to maintain a minimum maintenance margin. Due to stock market fluctuations, the margin account’s value might decrease below the minimum maintenance margin. This will require more funds to be added to the account.
Regulations: Regulations can also make short selling stocks risky. The SEC can impose restrictions on short sales in the market to avoid panic. This can result in rising stock prices forcing traders to cover their short positions at potentially enormous losses.
Costs of Short Selling Stocks
It costs money to buy and sell stocks. For example, a trading commission has to be paid to a broker to trade stocks. In addition to these normal trading commissions, short selling incurs a few different types of additional costs.
Stock Borrowing Costs: Some stocks are hard to borrow as they might be in limited supply or for other reasons. These stocks usually have a very high borrowing fee, and this fee can fluctuate substantially. Often the amount of the fee is not known in advance. The fee usually has to be paid at the end of each month or when the short trade closes. If it is high, it can affect the profitability of the stock short significantly.
Margin Interest: Short sales require margin accounts. When short positions are kept open for a long time, the margin interest accumulated can become a significant expense.
Dividends and Other Costs: short sellers are accountable for the stock’s dividend payments to the broker from whom the stock was borrowed. They also have to make payments for other unpredictable events related to this shorted stock, such as spin-offs and share splits.
When to Short a Stock?
Short selling stocks can be profitable if done at the right time. Entering too late can lead to lost profits because a part of the price decrease already happened. Enter too early, and the costs involved in holding on to the short position for a longer period of time will rise significantly. Finally, if the short gets closed too late and the stock price has increased significantly, huge losses are inevitable as the stock needs to be bought at a price higher than what it sold was sold for.
An ideal time to short sell is during a bear market because investors can easily benefit from decreasing prices from the broad, deep market decline.
Short selling stocks can also work well when a stock’s fundamentals deteriorate. For example, when a company’s sales decline or profits deteriorate. Another situation where short selling stocks can be profitable is when the whole market shows signs of decline, economic indicators worsen, or there is a sign of a threatening geopolitical climate developing.
Experienced investors will usually wait until the bearish trend is confirmed before shorting a stock. This is because there are numerous technical indicators of bearish trends, for example, tightening credit conditions, which occurs when it becomes harder to borrow money from the bank.
Short selling stocks is different from regular investing and has its advantages and limitations. Shorting a stock is risky and can easily result in massive losses if the stock’s price movement’s expectations are incorrect. There is no limit to the losses of a short-sale trading strategy.
However, risky strategies often offer high rewards. For example, short selling stocks can result in huge profits if the seller can predict the price increases and decreases correctly. Hedge fund managers are the most active short-sellers as they use these positions in stocks to counterbalance their long positions. Short selling stocks is a risky strategy. So, it should only be attempted by seasoned traders who have experience analyzing the markets, assessing the risks, and having impeccable timing on when to buy and sell.
Here is an interesting short selling academic research paper by the World Federation of Exchanges, published in April 2020, that discusses short selling bans.