Short selling is an investment or trading strategy that speculates on the decline in a stock or other security’s price. It is an advanced strategy that should only be undertaken by experienced traders and investors.
Traders may use short selling as speculation, and investors or portfolio managers may use it as a hedge against the downside risk of a long position in the same security or a related one. Speculation carries the possibility of substantial risk and is an advanced trading method. Hedging is a more common transaction involving placing an offsetting position to reduce risk exposure.
In short selling, a position is opened by borrowing shares of a stock or other asset that the investor believes will decrease in value. The investor then sells these borrowed shares to buyers willing to pay the market price. Before the borrowed shares must be returned, the trader is betting that the price will continue to decline and they can purchase the shares at a lower cost. The risk of loss on a short sale is theoretically unlimited since the price of any asset can climb to infinity.
With short selling, a seller opens a short position by borrowing shares, usually from a broker-dealer, hoping to buy them back for a profit if the price declines. Shares must be borrowed because you cannot sell shares that do not exist. To close a short position, a trader buys the shares back on the market—hopefully at a price less than at which they borrowed the asset—and returns them to the lender or broker. Traders must account for any interest charged by the broker or commissions charged on trades.
To open a short position, a trader must have a margin account and will usually have to pay interest on the value of the borrowed shares while the position is open. Also, the Financial Industry Regulatory Authority (FINRA), which enforces the rules and regulations governing registered brokers and broker-dealer firms in the United States, the New York Stock Exchange (NYSE), and the Federal Reserve have set minimum values for the amount that the margin account must maintain—known as the maintenance margin.
If an investor’s account value falls below the maintenance margin, more funds are required, or the position might be sold by the broker.
The process of locating shares that can be borrowed and returning them at the end of the trade is handled behind the scenes by the broker. Opening and closing the trade can be made through the regular trading platforms with most brokers. However, each broker will have qualifications that the trading account must meet before they allow margin trading.
The most common reasons for engaging in short selling are speculation and hedging. A speculator is making a pure price bet that it will decline in the future. If they are wrong, they will have to buy the shares back higher, at a loss. Because of the additional risks in short selling due to the use of margin, it is usually conducted over a smaller time horizon and is thus more likely to be an activity conducted for speculation.
People may also sell short to hedge a long position. For instance, if you own call options (which are long positions), you may want to sell short against that position to lock in profits. Or, if you want to limit downside losses without actually exiting a long stock position, you can sell short in a stock that is closely related to or highly correlated with it.
Selling short can be costly if the seller guesses wrong about the price movement. A trader who has bought stock can only lose 100% of their outlay if the stock moves to zero.
However, a trader who has shorted stock can lose much more than 100% of their original investment. The risk comes because there is no ceiling for a stock’s price—it can rise “to infinity and beyond,” to coin a phrase from comic character Buzz Lightyear. Also, while the stocks were held, the trader had to fund the margin account. Even if all goes well, traders have to figure in the cost of the margin interest when calculating their profits.
When it comes time to close a position, a short seller might have trouble finding enough shares to buy—if a lot of other traders are also shorting the stock or if the stock is thinly traded. Conversely, sellers can get caught in a short squeeze loop if the market, or a particular stock, starts to skyrocket.
On the other hand, strategies that offer high risk also offer a high-yield reward. Short selling is no exception. If the seller predicts the price moves correctly, they can make a tidy return on investment (ROI), primarily if they use margin to initiate the trade. Using margin provides leverage, which means the trader did not need to put up much of their capital as an initial investment. If done carefully, short selling can be an inexpensive way to hedge, providing a counterbalance to other portfolio holdings.
Beginning investors should generally avoid short selling until they get more trading experience under their belts. That being said, short selling through exchange-traded funds (ETFs) is a somewhat safer strategy due to the lower risk of a short squeeze.
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: Shorting is known as margin trading. When short selling, you open a margin account, which allows you to borrow money from the brokerage firm using your investment as collateral. Just as when you go long on margin, it’s easy for losses to get out of hand because you must meet the minimum maintenance requirement of 25%. If your account slips below this, you’ll be subject to a margin call and forced to put in more cash or liquidate your position.
Wrong Timing: Even though a company is overvalued, it could conceivably take a while for its stock price to decline. In the meantime, you are vulnerable to interest, margin calls, and being called away.
Short Squeeze: If a stock is actively shorted with a high short float and days-to-cover ratio (more on that below), it is also at risk of experiencing a short squeeze. A short squeeze happens when a stock begins to rise, and short sellers cover their trades by buying their short positions back. This buying can turn into a feedback loop. Demand for the shares attracts more buyers, which pushes the stock higher, causing even more short sellers to buy back or cover their positions.
Regulatory Risks: Regulators may sometimes impose bans on short sales in a specific sector, or even in the broad market, to avoid panic and unwarranted selling pressure. Such actions can cause a sudden spike in stock prices, forcing the short seller to cover short positions at huge losses.
Going Against the Trend: History has shown that, in general, stocks have an upward drift. Over the long run, most stocks appreciate in price. For that matter, even if a company barely improves over the years, inflation or the rate of price increase in the economy should drive its stock price up somewhat. This means that shorting is betting against the overall direction of the market.
Unlike buying and holding stocks or investments, short selling involves significant costs, in addition to the usual trading commissions that have to be paid to brokers. Some of the costs include:
Margin Interest: Margin interest can be a significant expense when trading stocks on margin. Since short sales can only be made via margin accounts, the interest payable on short trades can add up over time, especially if short positions are kept open over an extended period.
Stock Borrowing Costs: Shares that are difficult to borrow—because of high short interest, limited float, or any other reason—have “hard-to-borrow” fees that can be quite substantial. The fee is based on an annualized rate that can range from a small fraction of a percent to more than 100% of the value of the short trade and is prorated for the number of days that the short trade is open.
As the hard-to-borrow rate can fluctuate substantially from day to day and even on an intraday basis, the exact dollar amount of the fee may not be known in advance. The fee is usually assessed by the broker-dealer to the client’s account either at month-end or upon closing of the short trade—and if it is quite large, can make a big dent in the profitability of a short trade or exacerbate losses on it.
Dividends and Other Payments: The short seller is responsible for making dividend payments on the shorted stock to the entity from whom the stock has been borrowed. The short seller is also on the hook for making payments on account of other events associated with the shorted stock, such as share splits, spinoffs, and bonus share issues, all of which are unpredictable events.
Two metrics used to track short-selling activity on a stock are:
Short interest ratio (SIR)—also known as the short float—measures the ratio of shares that are currently shorted compared to the number of shares available or “floating” in the market. A very high SIR is associated with stocks that are falling or stocks that appear to be overvalued.
The short interest to volume ratio—also known as the days-to-cover ratio—is the total shares held short divided by the average daily trading volume of the stock. A high value for the days-to-cover ratio is also a bearish indication for a stock.
Both short-selling metrics help investors understand whether the overall sentiment is bullish or bearish for a stock.
Unexpected news events can initiate a short squeeze, which may force short sellers to buy at any price to cover their margin requirements. For example, in October 2008, Volkswagen briefly became the most valuable publicly traded company in the world during an epic short squeeze.
In 2008, investors knew that Porsche was trying to build a position in Volkswagen and gain majority control. Short sellers expected that once Porsche had achieved control over the company, the stock would likely fall in value, so they heavily shorted the stock. However, in a surprise announcement, Porsche revealed that they had secretly acquired more than 70% of the company using derivatives, which triggered a massive feedback loop of short sellers buying shares to close their position.
Short sellers were at a disadvantage because 20% of Volkswagen was owned by a government entity that wasn’t interested in selling, and Porsche controlled another 70%, so there were very few shares available on the market—float—to buy back. Essentially, both the short interest and days-to-cover ratio had exploded higher overnight, which caused the stock to jump from the low €200s to more than €1,000.
A characteristic of a short squeeze is that they tend to fade quickly, and within several months, Volkswagen’s stock had declined back to its normal range.
Timing is crucial when it comes to short selling. Stocks typically decline much faster than they advance, and a sizable gain in a stock may be wiped out in a matter of days or weeks on an earnings miss or other bearish development. The short seller thus has to time the short trade to near perfection. Entering the trade too late may result in a huge opportunity cost in terms of lost profits, since a major part of the stock’s decline may have already occurred.
On the other hand, entering the trade too early may make it difficult to hold on to the short position in light of the costs involved and potential losses, which would skyrocket if the stock increases rapidly.
There are times when the odds of successful shorting improve, such as the following:
During a Bear Market: The dominant trend for a stock market or sector is down during a bear market. So traders who believe that “the trend is your friend” have a better chance of making profitable short sale trades during an entrenched bear market than they would during a strong bull phase. Short sellers revel in environments where the market decline is swift, broad, and deep—like the global bear market of 2008–09—because they stand to make windfall profits during such times.
When Stock or Market Fundamentals Are Deteriorating: A stock’s fundamentals can deteriorate for any number of reasons—slowing revenue or profit growth, increasing challenges to the business, rising input costs that are putting pressure on margins, and so on. For the broad market, worsening fundamentals could mean a series of weaker data that indicate a possible economic slowdown, adverse geopolitical developments like a threat of war, or bearish technical signals like reaching new highs on decreasing volume, deteriorating market breadth.
Experienced short sellers may prefer to wait until the bearish trend is confirmed before putting on short trades, rather than doing so in anticipation of a downward move. This is because of the risk that a stock or market may trend higher for weeks or months in the face of deteriorating fundamentals, as is typically the case in the final stages of a bull market.
Technical Indicators Confirm the Bearish Trend: Short sales may also have a higher probability of success when the bearish trend is confirmed by multiple technical indicators. These indicators could include a breakdown below a key long-term support level or a bearish moving average crossover like the death cross. An example of a bearish moving average crossover occurs when a stock’s 50-day moving average falls below its 200-day moving average. A moving average is merely the average of a stock’s price over a set period of time. If the current price breaks the average, either down or up, it can signal a new trend in price.
Valuations Reach Elevated Levels Amid Rampant Optimism: Occasionally, valuations for certain sectors or the market as a whole may reach highly elevated levels amid rampant optimism for the long-term prospects of such sectors or the broad economy. Market professionals call this phase of the investment cycle “priced for perfection,” since investors will invariably be disappointed at some point when their lofty expectations are not met. Rather than rushing in on the short side, experienced short sellers may wait until the market or sector rolls over and commences its downward phase.
John Maynard Keynes was an influential British economist whose economic theories are still in use today. However, Keynes was quoted as saying, “The market can stay irrational longer than you can stay solvent,” which is particularly apt for short selling. The optimal time for short selling is when there is a confluence of the above factors.
Sometimes short selling is criticized, and short sellers are viewed as ruthless operators out to destroy companies. However, the reality is that short selling provides liquidity—meaning enough sellers and buyers—to markets and can help prevent bad stocks from rising on hype and over-optimism. Evidence of this benefit can be seen in asset bubbles that disrupt the market. Assets that lead to bubbles such as the mortgage-backed security (MBS) market before the 2008 financial crisis are frequently difficult or nearly impossible to short.
Short-selling activity is a legitimate source of information about market sentiment and demand for a stock. Without this information, investors may be caught off-guard by negative fundamental trends or surprising news.
Unfortunately, short selling gets a bad name due to the practices employed by unethical speculators. These unscrupulous types have used short-selling strategies and derivatives to artificially deflate prices and conduct bear raids on vulnerable stocks. Most forms of market manipulation like this are illegal in the U.S. but still happen periodically.
Put options provide a great alternative to short selling by enabling you to profit from a drop in a stock’s price without the need for margin or leverage. If you’re new to options trading, Investopedia’s Options for Beginners course provides a comprehensive introduction to the world of options. Its five hours of on-demand video, exercises, and interactive content offer real strategies to increase consistency of returns and improve the odds in the investor’s favor.
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