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What is Short Selling? │ Examining a Popular Trading Strategy

What is Short Selling?
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8 minute read
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Short selling is a trading strategy that assumes that the price of an asset will decline. Shorting a stock is the inverse of traditional investing (“going long.”) To sell short, one first borrows shares of a security and sells them on the open market. After the price falls, the idea is to repurchase the shares and pocket the difference. The quantity of open short orders is what we refer to as short interest. It is an inverse barometer for market sentiment. 

This article will explain the mechanics of shorting a stock, and how traders can use short trades to profit from price declines.

What is Short Selling? 

Short selling is a trading strategy that traders who believe an asset’s price will decline tend to use. These individuals must have someone (usually a brokerage) willing to lend them the stock. They sell the borrowed shares, speculating that they can repurchase them in the future at a lower price. 

Unlike long positions, short positions carry a potentially unlimited downside. This is because brokers can close out a trader’s short position at any time. Since prices can theoretically rise to any level, the commitment to repurchase carries unlimited exposure. To hedge against these risks, short-sellers usually open stop orders (also known as “stop-loss” orders.) These execute when a stock’s price rises to a certain level, limiting the trader’s losses. 

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How Short Selling Works

All short-sellers must have what’s called a margin account, where brokers lend traders cash or securities. The requirements for opening margin accounts vary from firm to firm, but most require at least $2,000 in cash. Additionally, traders must have sufficient liquid reserves to borrow the security they want to short. Certain highly volatile securities might carry additional reserve requirements. 

Next, traders open an order to short the stock. Like any sell order, traders can choose to either take the market price or wait until the price meets a threshold using a limit order. In the latter case, they can also specify a timeframe. 

Once the short position is open, traders wait for the price to fall. You can close the position either by a market- or limit buy order. Additionally, short-sellers can open stop-loss orders. That order automatically closes the position after it reaches a certain loss threshold. 

The Costs of Shorting Stocks

The costs of opening a short position are more intricate than those associated with going long. The costs involved with shorting a stock include: 

Margin Fees: Like any other loan, borrowing securities from a broker is not free. Typical fees for margin loans on shares are in the neighborhood of 0.30% per annum. For especially desirable securities (e.g., so-called “hard-to-borrow” securities), costs may rise to 20-30% per year. 

Dividend Fees: If a borrowed share pays a dividend, it becomes a debt the short seller owes the broker. Likewise, the short trader bears any other costs associated with the stock (e.g., share splits, spin-offs, bonus share issues, etc.)

Investment Risk: If the price of a shorted security surges, the investor is responsible for buying back the stock at the inflated price. Since prices can move incredibly quickly, this risk may be unpredictable and large. 

Why do Traders Short Sell?

Traders open short positions to speculate on their beliefs that an asset price will fall. This gives them the flexibility to invest in securities they think will appreciate. It also opens up the possibility to earn money from ones they aren’t willing to own. (Long equity traders, on the other hand, can only earn from stocks by actually risking money on them.) 

Short positions can fill many portfolio functions and support various trading strategies. Hedge funds often open short positions to protect their long positions (i.e., as insurance). Other investors tend to short sectors or companies that are in the middle of sell-offs. Basically, companies they deem overvalued. Short selling can also generate income for so-called “stock scalpers,” who seek to capitalize on small intraday price movements. 

When Can It Be a Good Idea to Short Sell?

Short selling is worth considering whenever a trader believes an asset’s price will decline. For example, all of these can be reasons to go short: 

Negative News, such as underperforming earnings expectations, product recalls, or costly litigation. 

Weak Macroeconomic Fundamentals, such as a higher-than-expected unemployment rate, a viral disease, or political uncertainty. 

Overly Optimistic market sentiment, such as a steep run-up in the price without any apparent catalyst. 

However, it’s important to remember that governments and regulators are often skeptical of short traders. For example, European financial authorities suspended short sales during the March 2020 stock market crash. Likewise, American regulators banned short selling during the recession of 2008. Chinese officials reacted similarly to a crash in 2015.  

Examples of Short Selling

Suppose a trader felt that Tesla (TSLA) was overvalued at $500 a share. She might borrow 100 shares from her broker, opening a $50,000 short position. If that broker’s maintenance requirement for TESLA was 75% (as it is for the stock at some brokers), she’d be obliged to hold $37,500 in other liquidity in her account. 

She would sell those shares on the open market, collecting $50,000. If shares declined to $300 (as they did this week), she could repurchase for $30,000, and collect $20,000 in profit (before fees.)

However, if shares rose $200 instead of falling, the broker might issue a margin call, forcing her to inject more liquidity into her account. If she can’t meet the call, the broker could forcibly close her position, leaving her on the hook for the higher price. 

Differences Between Short Selling and Investing

As mentioned above, short selling is essentially the inverse of traditional investing. Long traders spend their money to acquire an asset, which they then sell later (ideally for a profit.) Short sellers, on the other hand, sell the asset first – before they even own it! And their profit comes from the downwards movement in price.

In terms of risk, long traders stand to lose only their initial investment (i.e., if the stock price falls to $0.) Short traders, on the other hand, stand to lose potentially limitless amounts; the stock price could rise to any level. 

Long traders also have an easier time executing their orders, as leverage (buying with borrowed cash) isn’t a requirement for investing. Whereas short selling requires one by necessity to sell borrowed shares.

Pros and Cons of Short Selling

Advantages

There are plenty of potential upsides to short selling. These include: 

Flexibility.

Long traders can only profit on securities they are willing to own. Troubled assets that are expected to decline, for example, are seldom suitable for long positions. But short traders don’t require ownership to profit; they make money on borrowed shares. So the asset space open to short traders is much larger. 

Collateral Income.

Using an existing portfolio as collateral for a margin loan enables those idle assets to support new income. 

Hedging.

Long investors are 100% bullish by definition – they win in good times and lose in bad times. Short selling allows investors to hedge their risks. This lets them gain some bearish exposure to specific companies and sectors, or to the entire market. 

Disadvantages

There are some serious drawbacks to short positions, however. These include: 

Unlimited Downside.

As mentioned above, since short positions force traders to repurchase the asset in the future, the short seller may be on the hook for a hefty bill. This happened to short traders on KaloBios (KBIO), for example, some of whom were bankrupted after the company received unexpected outside money and surged 800% overnight. 

Additional Fees.

Since short trades involve borrowed securities, they face costs in excess of simple long orders. These include margin fees (analogous to interest on a loan) and borrowing fees, as well as costs associated with dividends and other financial events. 

Execution Difficulties.

Many governments and regulators hold short selling in dim regard. They sometimes believe short traders exacerbate negative price cascades and/or engage in unscrupulous manipulation. During economic crises, it’s not uncommon for short trades to be restricted entirely for some time.

What are the Risks of Short Selling?

In general, the risks of short selling are twofold: 

Price Risk. Security prices don’t always decline when we’d like them to. If a trader speculates on a company’s share price falling, and it defies expectations and continues to rise, the short position has incurred a loss. 

Execution Risk. As above, it’s not guaranteed that traders will be able to open or modify their short positions at will. Incorporating short selling into an investment strategy may mean depending on a risky trade class. 

Is Short Selling Worth It?

There are certainly cases where short selling is justifiable. For example, one has good reason to believe an asset will decline, or if the general economy doesn’t support equity valuations. Selling short might also be motivated by one’s overall risk position. If one is extremely long in the tech sector, opening short positions in a few key players might be a good hedge. 

That said, the overall question hinges on the risk/reward profile. This boils down to the securities in question, the terms of credit (i.e., maintenance requirements and margin fees), and the economic environment. 

Final Thoughts

Short selling is a relatively refined strategy. You can sometimes use it to generate returns even in bad economic times. If one understands the risks (unlimited downside), hedges them properly (stop-limit order), and has the appropriate infrastructure to short (margin account), selling short can become a valuable instrument in one’s financial arsenal. 

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