A trading or investment strategy that speculates that the price of a stock or other security will decrease, short selling is an advanced strategy that should only be used by experienced investors. A more common transaction, hedging involves placing an offsetting position to limit risk exposure. Portfolio managers and investors often use shorting a stock to hedge against the adverse risk of a long position. While investors can make significant profits with short selling, the risk of loss associated with it is theoretically unlimited as the price of any stock can increase to infinity.
- Short selling happens when investors borrow a stock and sell it on the open market to buy it back at a lower cost.
- Short-sellers bet on a stock price dropping to make a profit.
- There is a high risk/reward ratio associated with short selling: It can produce large profits, but losses can accumulate quickly and infinitely.
How Does Shorting a Stock Work?
When short selling, investors open a position by borrowing stock shares, typically from a broker-dealer. They then attempt to profit on the use of said share before having to return to them to the lender. Investors need to have a margin account to open a short position and generally have to pay interest on the value of the share they borrow while the position is open.
The Financial Industry Regulatory Authority, Inc (FINRA) enforces the regulations and rules governing registered broker-dealer firms and brokers in the U.S., the Federal Reserve, and the New York Stock Exchange (NYSE). FINRA has also established the maintenance margin, or set minimum values margin accounts must maintain. When an account’s value falls below the maintenance margin, investors need to add more funds, or the broker may sell the position.
To close a short position, an investor purchases shares back on the market, ideally at a lower price than what they borrowed the stock at, and returns them to the broker. Investors also need to account for any interest or commissions charged.
Investors can open and close trades through regular trading platforms while locating shares to borrow, and returning them at the end is handled by the broker behind the scenes. Each broker will have a set of qualification trading accounts you are required to meet before allowing margin trading.
Speculation is one of the main reasons investors engage in short selling. Traditional long strategies where stocks are purchased can be classified as either speculation or investment based on two parameters:
- The degree of risk the investor undertakes
- The time horizon
Generally, investing is lower risk with a long-term time horizon spanning years or even decades. Speculation is a significantly higher-risk with typically short-term time horizons.
Short Selling Risks
In addition to the risk of losing money on a trade if a stock’s price increases, there are other risks associated with short selling investors should consider:
- The Short Squeeze: Short squeezes happen when investors short-selling cover their positions on a stock. This results in buying volume that increases the price of the stock. This can happen if the price has increased to a level where investors need to make margin calls or simply cut their losses and get out.
- Regulatory Risks: Regulators can sometimes place bans on short sales in specific sectors or the broad market to avoid unwarranted pressure to sell and panic. These actions may result in a sudden spike of a stock’s price and force investors to cover their short positions at a considerable loss.
- Going Against the Trend: Historically, stocks have an upward drift, meaning long-term the majority of stocks increase in price. Even with companies barely improving, inflation should result in the stock price increasing. The bottom line — shorting a stock is betting against the market’s overall direction.
Costs of Short Selling
Unlike purchasing and holding investments or stocks, short selling includes significant costs. This is in addition to the traditional trading commissions that investors pay to brokers. Some of these costs include:
- Margin Interest: Margin interest can be a large expense when trading investments on margin. Since margin accounts are required for short sales, the payable interest on short trades can quickly add up, especially when short positions are kept open for extended periods of time.
- Stock Borrowing Costs: Stocks that are difficult to borrow due to limited float, high short interest, or other reasons can have substantial hard-to-borrow fees attached to them. This fee is determined using an annual rate ranging from a minimal fraction of a percent to over 100% of the short trade’s value. Hard-to-borrow fees are pro-rated based on the number of days a short trade is open.
- Dividends and other Payments: Short sellers are responsible for any dividend payments on shorted stocks due to the entity they borrowed the stocks from. Short sellers are also responsible for making payments on any other events the short stock is associated with, including bonus share issues, share splits, and spin-offs. Unfortunately, all of these are unpredictable events.
Ideal Conditions for Short Selling
Timing is essential with short selling. Stocks generally decline faster than they increase, and sizable gains for a stock can be eliminated in a couple days or weeks due to an earnings miss or other types of bearish developments. This requires investors to time short trades nearly to perfection. If they enter trades too late, they risk missing out on profits since the majority of the stock’s decline has already occurred. Entering too early results in difficulty holding onto the short position due to potential losses and costs involved, both of which would skyrocket if the price of the stock quickly increases.
There are times when successful shorting odds improve, including:
- During a Bear Market: During a bear market, the dominant trend of stocks is down. Investors believing trends are useful tools tend to have an increased chance for profitable short sales during a bear market than they would during a stronger bull market. Short selling investors thrive in swift, deep, and broad market declines as they stand to make incredible profits during this time.
- When Stock or Market Fundamentals are Deteriorating: Stock fundamentals may deteriorate for several reasons, including rising input costs that are increasing pressure on margins, slowing profit growth or revenue, and increasing business challenges, to name a few.
- For the broad market, worsening fundamentals could mean deteriorating market breadth, a series of weaker data that indicate a possible economic slowdown, bearish technical signals like reaching new highs on decreasing volume, or adverse geopolitical developments like the threat of war.
- Experienced short-selling investors often prefer waiting for a confirmed bearish trend before making short trade puts instead of moving ahead based on a perceived downward move.
- Technical Indicators Confirm the Bearish Trend: Having a bearish trend confirmed by several technical indicators provides investors a higher probability of successful short sales. These indicators may include a bearish moving average crossover such as the “death cross” or a breakdown below a key long-term support level.
- A moving average is simply a stock price’s average over a period of time. A bearish moving average crossover happens when a security’s 50-day moving average dips below it’s 200-day moving average. If the current price of a stock breaks the average either up or down may signal a new price trend.
- Valuations Reach Elevated Levels Amid Rampant Optimism: Valuations for specific sectors or the entire market can sometimes reach elevated levels due to rampant optimism of the long-term outlook of the stock or market. Market experts refer to this as being priced for perfection since investors will eventually be disappointed when high expectations are not met. Instead of rushing in, experienced short-sellers usually wait until the sector or market rolls over and continues with the downward phase.
Not many investors use the short-selling strategy due to the overall expectation that stocks and the market as a whole will eventually increase in value. Especially for investors looking at the long-term, purchasing stocks carries less risk than attempting to short-selling the market. Learn more about the short sale stock process and how you can profit from short-selling by scheduling a free online training session with one of Raging Bull’s team of marketing experts.