What Is Short Selling?
Short selling is a trading strategy where investors speculate on a stock's decline. Short sellers bet on, and profit from a drop in a security’s price. Traders use short selling as speculation, and investors or portfolio managers may use it as a hedge against the downside risk of a long position.
Key Takeaways
- Short selling occurs when an investor borrows a security and sells it on the open market, planning to repurchase later for less money.
- Short sellers bet on and profit from, a drop in a security’s price.
- Short selling has a high risk/reward ratio, offering big profits, but losses can mount quickly and may result in margin calls.
How Short Selling Works
Traders commonly engage in short selling for speculation and hedging. To open a short position, a trader must have a margin account and pay interest on the value of the borrowed shares while the position is open.
The Financial Industry Regulatory Authority (FINRA), which enforces the rules and regulations governing registered brokers andbroker-dealerfirms 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.
A broker handles locating shares that can be borrowed and returning them at the end of the trade. Opening and closing the trade can be done through regular trading platforms with brokers qualified to perform margin trading. To short-sell, traders commonly follow these steps:
- A seller opens a short position by borrowing shares, usually from a broker-dealer, hoping to repurchase them for a profit if the price declines.
- The investor then sells these borrowed shares to buyers willing to pay the market price. The trader is betting that the price will continue to decline and they can purchase the shares at a lower cost.
- To close a short position, a trader repurchases the shares—hopefully at a price less than they borrowed—and returns them to the lender or broker.
- Traders must account for any interest the broker charges or commissions on trades.
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Timing and Conditions
Timing is crucial when it comes to short selling. Stocks typically decline much faster than they advance, and a sizable gain in the stock may be wiped out with an earnings miss or other bearish development. Conversely, 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 rise if the stock increases rapidly.Short sellers commonly look for opportunities during the following conditions:
- Bear Market: 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, to make windfall profits during such times.
- Decline in Fundamentals: A stock’s fundamentals can deteriorate for several reasons—slowing revenue or profit growth, increasing challenges to the business, and rising input costs that pressure margins. Worsening fundamentals could indicate an economic slowdown, adverse geopolitical developments like a threat of war, or bearish technical signals like new highs on decreasing volume.
- Bearish Technical Indicators: Short sales may succeed when technical indicators confirm the bearish trend. 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. If the current price breaks the average, either down or up, it can signal a new trend in price.
- High Valuations: 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.
Short Selling Costs
Unlike buying and holding stocks or investments, short selling involves significant costs in addition to the usual trading commissions paid to brokers. Some costs include:
- Margin Interest: Since short sales can only be made via margin accounts, the interest payable on short trades can add up, 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 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. The broker-dealer usually assesses the fee to the client’s account.
- Dividends and Other Costs: The short seller is responsible for making dividend payments on the shorted stock to the entity from which the stock was borrowed. For shorted bonds, they must pay the lender the coupon or interest owed.
Shorting is known asmargin trading. Traders borrow money from the brokerage firm using the investment as collateral.Investors must meet the minimum maintenance requirement of 25%. If the account slips below this, traders are subject to amargin call and forced to put in more cash or liquidate their position.
Short Selling Strategies
Profit
Imagine a trader who believes that XYZ stock—currently trading at $50—will decline in price in the next three months. They borrow 100 shares and sell them to another investor. The trader is now “short” 100 shares since they sold something they did not own but had borrowed.
A week later, the company whose shares were shorted reports dismal financial quarterly results, and the stock falls to $40. The trader closes the short position and buys 100 shares for $40 on the open market to replace the borrowed shares. The trader’s profit on the short sale, excluding commissions and interest on the margin account, is $1,000, based on the following calculations: $50 - $40 = $10 and $10 x 100 shares = $1,000.
Loss
Using the scenario above, suppose the trader did not close out the short position at $40 but decided to leave it open to capitalize on a further price decline. However, a competitor swoops in to acquire the company with a takeover offer of $65 per share, and the stock soars.
If the trader decides to close the short position at $65, the loss on the short sale would be $1,500, based on the following calculations: $50 - $65 = negative $15, and negative $15 × 100 shares = $1,500 loss. In this case, the trader had to buy back the shares at a significantly higher price to cover their position.
Hedge
The primary objective of hedging is protection, as opposed to the profit motivation of speculation. Hedging aims to protect gains or mitigate losses in a portfolio. The costs of hedging are twofold. There’s the actual cost of putting on the hedge, such as the expenses associated with short sales, or the premiums paid for protective options contracts.
Also, there’s the opportunity cost of capping the portfolio’s upside if markets continue higher. If 50% of a portfolio with a close correlation to the Standard & Poor’s 500 Index (S&P 500) is hedged, and the index moves up 15% over the next 12 months, the portfolio would only record approximately half of that gain, or 7.5%.
Investors can choose short selling through exchange-traded funds (ETFs), a safer strategy due to the lower risk of ashort squeeze. Put options provide an alternative to short selling by enabling investors to profit from a stock price drop without the need for margin.
Advantages and Disadvantages
If the seller predicts the price moves correctly, they can make a positive return on investment, primarily if they use margin to initiate the trade. Using margin provides leverage, which means the trader does not need to put up much of their capital as an initial investment. If done carefully, short selling can be an inexpensive hedge, a counterbalance to other portfolio holdings.
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. Also, while the stocks were held, the trader had to fund the margin account. When it comes time to close a position, a short seller might have trouble finding enough shares to buy—if many other traders are shorting the stock or 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. A short squeeze happens when a stock rises, and short sellers cover their trades by buying back their short positions.
Pros
Possibility of high profits
Little initial capital required
Leveraged investments possible
Hedge against other holdings
Cons
Potentially unlimited losses
Margin account necessary
Margin interest incurred
Short squeezes
Regulations
Each country sets restrictions and regulates short-selling in its markets. In the U.S., short selling is regulated by the U.S. Securities and Exchange Commission (SEC) under the Securities Exchange Act of 1934. Regulation SHO, implemented in 2005, is the primary rule governing short selling that mandates short sales can only be executed in a tick-up or zero-plus tick market, meaning the security price must be moving upward at the time of the short sale.
According to Regulation SHO, brokers must locate a party willing to lend the shorted shares, or they must have reasonable grounds to believe that the shares could be borrowed. This prevents naked short selling, where investors sell shares they have not borrowed.The SEC can impose temporary short-selling bans on specific stocks under certain conditions, such as extreme market volatility.
In October 2023, the SEC added regulations requiring investors to report their short positions to the SEC and companies that lend shares for short selling to report this activity to FINRA. These new rules come after increased scrutiny of short selling, particularly following the GameStop (GME) meme stock saga in 2021, when retail investors drove up the stock price, causing losses for hedge funds that had shorted the company.
Regulations vary by region. The European Securities and Markets Authority (ESMA) oversees short selling in the EU. Positions exceeding 0.2% of issued shares must be disclosed to regulators, and those exceeding 0.5% must be publicly disclosed. In Hong Kong, the Securities and Futures Commission (SFC) regulates short selling which is only allowed for designated securities and must be backed by borrowed shares. Naked short selling is illegal.
Example
Unexpected news events can initiate a short squeeze, forcing short sellers to buy at any price to cover their margin requirements. In October 2008, due to a short squeeze, Volkswagen briefly became the most valuable publicly traded company.
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 to buy back the stock. Essentially, both the short interest and days-to-cover ratio exploded overnight, which caused the stock price to jump from the low €200s to more than €1,000.
Why Do Short Sellers Have to Borrow Shares?
Since a company has a limited number of outstanding shares, a short seller must first locate shares. The short seller borrows those shares from an existing long and pays interest to the lender. This process is often facilitated behind the scenes by a broker. If a small amount of shares are available for shorting, then the interest costs to sell short will be higher.
What Are Short Selling Metrics?
Short-selling metrics help investors understand whether overall sentiment is bullish or bearish. The short interest ratio (SIR)—also known as the short float—measures the ratio of shares 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.
Why Does Short Selling Have Negative Reputation?
Unfortunately, short selling gets a bad name due to the practices employed by unethical speculators who have used short-selling strategies and derivatives to deflate prices and conduct bear raids on vulnerable stocks artificially. Most forms of market manipulation like this are illegal in the U.S. but may happen periodically.
What Is a Short Squeeze?
Because in a short sale, shares are sold on margin, relatively small rises in the price can lead to even more significant losses. The holder must buy back their shares at current market prices to close the position and avoid further losses. This need to buy can bid the stock price higher if many people do the same thing. This can ultimately result in a short squeeze.
The Bottom Line
Short selling allows investors and traders to make money from a down market. Those with a bearish view can borrow shares on margin and sell them in the market, hoping to repurchase them at some point in the future at a lower price. While some have criticized short selling as a bet against the market, many economists believe that the ability to sell short makes markets more efficient and can be a stabilizing force.
