I . What Is short selling?
Short selling, (also called short sale) 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 them 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.
- Short selling occurs when an investor borrows a security and sells it on the open market, planning to buy it back later for less money.
- Short-sellers bet on, and profit from, a drop in a security's price. This can be contrasted with long investors who want the price to go up.
- Short selling has a high risk/reward ratio: It can offer big profits, but losses can mount quickly and infinitely due to margin calls.
II . Understanding Short Selling
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 what 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, Inc. (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 the trading account must meet before they allow margin trading.
III. Example of Short Selling
Example of Short Selling for a 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 that they did not own but had borrowed. The short sale was only made possible by borrowing the shares, which may not always be available if the stock is already heavily shorted by other traders.
A week later, the company whose shares were shorted reports dismal financial results for the quarter, and the stock falls to $40. The trader decides to close 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: ($50 - $40 = $10 x 100 shares = $1,000).
Example of Short Selling for a Loss
Using the scenario above, let's now 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: ($50 - $65 = negative $15 x 100 shares = $1,500 loss). Here, the trader had to buy back the shares at a significantly higher price to cover their position.
Example of Short Selling as a Hedge
Apart from speculation, short selling has another useful purpose—hedging—often perceived as the lower-risk and more respectable avatar of shorting. The primary objective of hedging is protection, as opposed to the pure profit motivation of speculation. Hedging is undertaken to protect gains or mitigate losses in a portfolio, but since it comes at a significant cost, the vast majority of retail investors do not consider it during normal times.
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 to move higher. As a simple example, if 50% of a portfolio that has a close correlation with the S&P 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%.
IV. Advantages & Disadvantages
- Possibility of high profits
- Little initial capital required
- Leveraged investments possible
- Hedge against other holdings
- Potentially unlimited losses
- Margin account necessary
- Margin interest incurred
- Short squeezes