Short Selling

Have you ever been absolutely sure that a stock was going to decline and wanted to profit from that? Have you ever wished you could see your portfolio increase in value during a bear market? Both scenarios are possible. Many investors make money on a decline in an individual stock or during a bear market, thanks to an investing technique called short selling. 

Short selling makes it possible to sell what one does not own, by borrowing the asset or instrument in question, selling it, and then buying it back (hopefully at a cheaper price) to replace the borrowed asset. As the seller does not own the asset, the process of selling it creates a short position (think of it as a shortfall) that must eventually be covered by buying it back on the market. The difference between the initial sale price and the price at which the asset was brought back represents the short seller’s profit or loss.

Short selling is also known as “shorting,” “selling short,” or “going short.” To be short a security or asset implies that one is bearish on it and expects the price to decline.

Short selling can be used for purposes of speculation or hedging. While speculators use short selling to capitalize on a potential decline in a specific security or the broad market, hedgers use the strategy to protect gains or mitigate losses in a security or portfolio. Hedge funds are among the most active short sellers, and often use short positions in select stocks or sectors to hedge their long positions in other stocks.

Short sellers are often portrayed as hardened individuals who are bent on profits and want the companies they target to fail. Additionally, many investors view short selling as an inordinately dangerous strategy, since the long-term trend of the equity market is generally upward and there is theoretically no upper limit to how high a stock can rise.

While shorting is inherently risky, the reality is that short sellers facilitate smooth functioning of the markets by providing liquidity, and also act as a reality check on overhyped stocks, especially during periods of irrational exuberance. Stocks may trade at sky-high levels or absurd valuations in the absence of short sellers’ restraining influence, and investors who buy into the hype could face massive losses in the inevitable correction.

Under the right circumstances, short selling can be a viable and profitable investment strategy for experienced traders and investors who have an adequate degree of risk tolerance and are familiar with the risks involved in shorting. Relatively inexperienced investors would also do well to learn about the basic aspects of short selling through learning tools like this tutorial in order to expand their investing toolkit.

First, let’s describe what short selling means when you purchase shares of stock. In purchasing stocks, you buy a piece of ownership in the company. The buying and selling of stocks can occur with a stock broker or directly from the company. Brokers are most commonly used. They serve as an intermediary between the investor and the seller and often charge a fee for their services.

When using a broker, you will need to set up an account. The account that’s set up is either a cash account or a margin account. A cash account requires that you pay for your stock when you make the purchase, but with a margin account the broker lends you a portion of the funds at the time of purchase and the security acts as collateral.

When an investor goes long on an investment, it means that he or she has bought a stock believing its price will rise in the future. Conversely, when an investor goes short, he or she is anticipating a decrease in share price.

Short selling is the selling of a stock that the seller doesn’t own. More specifically, a short sale is the sale of a security that isn’t owned by the seller, but that is promised to be delivered. That may sound confusing, but it’s actually a simple concept.

When you short sell a stock, your broker will lend it to you. The stock will come from the brokerage’s own inventory, from another one of the firm’s customers, or from another brokerage firm. The shares are sold and the proceeds are credited to your account. Sooner or later, you must “close” the short by buying back the same number of shares (called covering) and returning them to your broker. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money.

Most of the time, you can hold a short for as long as you want, although interest is charged on margin accounts, so keeping a short sale open for a long time will cost more. Moreover, you can be forced to cover if the lender wants the stock you borrowed back. Brokerages can’t sell what they don’t have, so you will either have to come up with new shares to borrow, or you’ll have to cover. This is known as being called away. It doesn’t happen often, but is possible if many investors are short selling a particular security.

Because you don’t own the stock you’re short selling (you borrowed and then sold it), you must pay the lender of the stock any dividends or rights declared during the course of the loan. If the stock splits during the course of your short, you’ll owe twice the number of shares at half the price. (To learn more about stock splits,

Example of a Short Selling Transaction

Let’s say Trader Travis has identified Fiscal Foibles, Inc. (obviously, a hypothetical stock) as an appropriate short-selling candidate whose accounting shenanigans are poised to catch up with it. Travis decides to short 100 shares of the company, currently trading at $100. Here are the steps involved in the short selling process:

1. Travis places the short sale order through his online brokerage account or financial advisor. Travis must declare the short sale as such when entering the order, since an undeclared short sale amounts to a violation of securities laws. He would also need to ensure that he has a minimum of $5,000 (50% of $100 X 100 shares) as capital in his margin account prior to making the short trade.
2. Travis’s broker will attempt to borrow the shares from a number of sources: its own inventory, from the margin accounts of one of its clients, or from another broker-dealer. The Securities and Exchange Commission (SEC)’s Regulation SHO, which went into effect in January 2005, imposes a “locate” requirement on a broker-dealer prior to making a short sale. This requires a broker-dealer to have reasonable grounds to believe that the security to be shorted can be borrowed, so that it can be delivered to the buyer on the date that delivery is due.
3. Once the shares have been borrowed or “located” by the broker-dealer, they will be sold in the market and the proceeds deposited in Travis’s margin account.

Travis’s margin account now has $15,000 in it, $10,000 from the short sale of 100 shares of Fiscal Foibles at $100, plus $5,000 (50% of $10,000) as Travis’s margin deposit.

Let’s say that the next day the stock is trading at $110. Since the margin account has to hold a minimum of 150% of the current price of the stock that has been shorted, the maintenance margin based on the market price is now $5,500 (50% x 100 x $110). Travis had already contributed $5,000 as margin when the short sale was made, but the maintenance margin level of $5,500 means that his account balance is deficient by $500. He will, therefore, receive a margin call from his broker demanding that the margin shortfall be rectified immediately. Travis will have to inject an additional $500 into the margin account to meet the maintenance margin requirement.

Let’s say that Fiscal Foibles trades between $100 and $110 for the next few days, and after a week, declines to $90. Travis decides to close out the short position by buying back the 100 shares that were sold short, at a total cost of $9,000. Therefore, his gross profit (before costs and commissions) would be $1,000.

On the other hand, suppose Fiscal Foibles decides to clean up its act, as a result of which the stock spikes to $120. At this price, Travis decides to close out his short position rather than run the risk of mounting losses. In this case, his loss would be $2,000 ($10,000- $12,000).