When an investor shorts a stock, it means that they are betting on the price of the stock dropping. In theory, it’s the same thing as betting on a sports team to lose. Unlike traditional trading, the investor will never actually own any stock during the shorting process. During the short selling process, they are essentially borrowing shares. They then will sell the stocks back at the current market price, betting that the price of the stock will have decreased before they are forced to repay the stock, so they can pick it up cheaper.
To completely understand the shorting process, you will need to know:
- Why do some investors choose to short sell?
- What short selling looks like
- Why short selling is risky
- Why short selling might be a good option
- What the risks of short selling are
What Is Shorting a Stock For?
The goal of short selling is to profit off of a company’s stock declining, or the company going bankrupt before a certain date, known as the expiration period. The short seller will agree to sell the buyer a stock for the price it is currently valued at and hopefully profit from the stock’s decline by being able to buy it at a lower price and sell it to the higher market value in the original agreement. By the end of this borrowing, the trader will pocket the difference after it has been adjusted for any dividends.
The dividend income will come out of the short seller’s pocket to cover the cost that is no longer available for the original shares. One drawback is that if the stock is borrowed through a brokerage firm, then the dividend replacement will not count as qualified dividends entitled to specialized tax rates.
An Example of Short Selling
To understand why investors short stocks, it is crucial to understand how the process works. Say, for example, that you are looking to short 200 shares of ABC Company because your research has predicted that they will have lower-than-expected next quarter earnings. When you began the process, the stock was trading at $38.50 per share, and you intend to borrow the 200 shares from your broker for a total value of $7,700. With this situation, there are two possible outcomes.
- An outcome that is profitable: Say that you have been sitting on the short position for close to a year and you have been required to pay a replacement dividend of $172. The stock has dropped 20% on the market to a value of $30.48. This means you can buy back the 200 shares at the lower price for a total cost of $6096.00. Your profit before any commission charges would be the original price of $7,700 minus the dividend payments and the new cost you paid for the stock. In the end, you would have a profit of $1,432 minus the commission, which can vary by broker.
- An outcome that results in a loss: Unfortunately, not all short-selling positions are profitable. For example, you may have shorted the stock of a company that makes an announcement of a new acquisition that is now raising the price of their stock to $50 per share. This means that before the expiration date, you will need to rebuy the 200 shares of stock at the $50 per share rate for a total of $10,000. Therefore you have lost $2,300 on the price of the stock as well as any dividends and commission.
Another example to help you better understand what is involved in short selling is deciding to purchase stock from XYZ. Through your research, you have determined that the stock is grossly overvalued and likely to experience a plummet in the near future. You decide to borrow 20 shares of XYZ stock from your broker and sell them at the current higher market value. The end goal is to repurchase them when the stock plummets and give them back to the broker to settle, pocketing whatever the difference is.
Why Shorting Stock Should Be Left to Experienced Investors
One important thing to note about short selling is that many brokerages may restrict your ability to short trade to whether or not you have a margin account. Cash accounts with no margin are often not used for short selling. This is due to the fact that the potential losses when short selling can be unlimited. So for those who wish to prevent short sellers from borrowing their shares, it may be best to open a cash account with the brokerage instead of a margin account to have greater control.
Since short selling is high risk and requires a margin account, that means that you will be personally guaranteeing the money to cover any losses. If you don’t have the cash funds available to cover a margin call, you will be unable to pay it back with payments. Instead, you would have to liquidate your assets to come up with the funds.
This can mean catastrophic consequences for investors who are not as experienced or may not fully understand the possible risks. A more experienced investor will try to cover their exposure to risk by creating offset protections, such as buying out-of-the-money options that are matched appropriately.
Why Would an Investor Be Motivated to Short Sell?
Short selling can be an extremely profitable transaction, does not require much capital to get started, and can allow investors to still actively make money even in a down market. Many short sellers will perform these kinds of investments just for speculation. For other investors, it is a way to hedge the downside risk in a long-term position. When investors do this, they will already own shares of the same stock or a related stock.
There are also some investors who enjoy more risky investments and have put their work in, researching and following stock trends to ensure they are making informed and smart decisions about which stocks to short to maximize profit and minimize loss.
What Does It Mean to Short a Stock: the Risks
As mentioned before, selling short can expose you to a significant financial risk. In some cases, investors may see that many speculators have shorted a big percentage of a company’s stock. This can show a large short interest. When seeing this, some companies may drive the stock price up to force all of the short position speculators to purchase back their shares early to reduce the risk of paying even higher prices, and the shares continue to rise. This provides some control over the price of the stock before all of the speculators who have shorted it suffer catastrophic losses.
But this is not always the case with short selling, so never assume that you will automatically be able to purchase back the stock at any given time. There has to be a market for the stock to be able to get out of the position early. There will need to be people selling the stock to be able to close.
Another factor that could cause a problem with closing your position early is the presence of a large number of buyers, including panic buyers, which is a common occurrence as more and more short sellers attempt to close their positions early, to avoid more significant losses as the stock continues to increase.
Another major risk of short selling is sudden news of a company getting acquired. For example, an acquisition that is a 40% premium over the current price of the stock, plus a $10 per share dividend, which can immediately put short sellers in a loss position that is likely to get worse. You should always understand the volatility of stock prices and account for it when making a decision as to whether or not you should short sell.
You also should be aware that the opportunity to buy and sell when the stock is on its way up or down is not always possible. There is always the risk that the share price could go through an instant reset or that the ask and bid prices can suddenly jump significantly. In some cases, the risk loss can rise with no limit. When this happens, an inexperienced trader could possibly lose everything. Most seasoned traders will understand this and are knowledgeable about how to limit or cover potential losses.
A final thing to consider when shorting a stock is that it is subject to its own types of rules. For example, you are unable to short penny stocks unless the last trade is at a slight increase. To be successful at short selling, you need to understand these rules and how the process works.
Short selling is not for the faint of heart. While good instincts and proper research can provide for a great opportunity for profit, there is also the potential for unlimited losses. Novice investors may find themselves overexposed and having to liquidate other assets to cover a major loss. Want to learn more about the ins and outs of short selling? Sign up for our online webinar, or download our free e-book today.