What is Short Selling?

Short selling is kind of like Opposite Day…

To make money in the stock market, you have to buy low and sell high. Short selling attempts to do this, but in reverse order. Instead of buying first, you borrow shares, sell them first, and buy them back later, hopefully at a lower price. Once you buy them back, you can return them to the place you borrowed them from.

Short selling stock first requires you to have a margin account (an account authorized to borrow funds or stocks) with your broker. Regulations set minimum funding of the account, and the broker can require even higher minimums. Once you set up the necessary financing and the account, there are several steps to short selling.

All investments carry risk. Short selling is particularly risky — with theoretically infinite losses — and should not be undertaken by inexperienced traders or investors.

1. Open short position: Opening a short position is investing lingo for borrowing shares of stock to short sell them because you believe the price will fall. At this stage, you’ll acquire a specific number of shares from your broker and agree to the brokerage contract for borrowing the shares.
2. Sell the shares: Next, the shares of borrowed stock are sold on the stock market.
3. Incubation period: The incubation period is the time you wait for results. In this waiting phase, the investor watches the market and waits for the stock price to drop to the desired level. There is no guarantee that the stock price will drop, so the investor may have to decide to cut his losses if the price rises instead.
4. Close short position: Closing the short position, also called short-covering, means buying shares to replace the borrowed shares.
5. Reconciliation: If the price of the stock did drop, the investor has the potential to make a profit; but if the stock price rises, they have the potential to lose money. Once all the buying and selling is done, the profit or loss can be figured. Any fees for trading,borrowing the shares, or other costs are subtracted from the proceeds of the short sale. Even if the share price dropped, it might not have dropped enough to offset costs associated with short selling.

Brokers get shares to loan short sellers from several sources. Sometimes the broker has enough shares of stock in their brokerage inventory to cover the loan, sometimes they borrow them from the margin account of one of their customers, and sometimes they go outside the firm to get the shares from another lender.

Like with most investing activities, there are costs to short selling. There is a cost of borrowing the shares themselves. If the stock is considered hard to acquire (due to availability, high-interest rates, or other reasons), extra fees may be charged on top of standard borrowing costs. Those rates fluctuate and can range from a fraction of a percent of the value of the stock to over 100% of the stock value (on an annual basis). That percentage is prorated by the number of days the short position is open.

If short selling is done on margin — with borrowed cash — margin costs such as margin interest and fees also apply. Adding to all of that complexity, if a dividend or stock split is declared while the short position is open, the short seller may have to reimburse the lender for the value of that dividend or stock split.

While short selling does require a margin account, it is not quite the same thing. In buying on margin, cash is borrowed to help buy securities (a financial investment like stocks or bonds). In short selling, the shares themselves are borrowed and sold. Then, new shares are purchased to pay back the borrowed ones, hopefully, if and when the stock price drops. Short selling is generally a short-duration position (a relatively quick buy and sell cycle) compared to margin, usually being more of a long-duration position (planning on holding a security for a longer time to allow it to rise in value).

• Unlimited potential loss: There is always the potential for a stock to rise or fall. If a stock rises instead of falls, a short seller takes a loss. Because the potential for rising stock prices is unlimited, there is no limit to the amount that can be lost.
• Short-covering rally: During a short-covering rally, investors who are short selling a specific stock rush to close their short position (buy the stock) as the stock rises instead of falls. The added trading activity can drive the stock price even higher, leading even more short sellers to rush to close their short positions before the price gets even higher. This increase in price is called a short-covering rally because investors looking to close short positions are creating the rally in the price.
• Short squeeze: A short squeeze is pressure short traders experience on their profit and loss potentials during a short-covering rally. Once a short-covering rally starts, the losses begin to mount for those with open short positions. Some may begin to see earlier gains from price drops being erased but still have a little profit possibility left. This cycle effectively squeezes investors out of the short sale as short sellers rush to close positions.
• Costs: There are more costs with short selling than standard stock trades. In addition to trade costs, short sellers have to consider borrowing costs, interest, and they even might have to pay the broker for dividends or stock splits in some cases.
• May need to deposit additional funds. If the equity in your account falls below the minimum maintenance requirements (which varies according to the security), you’ll have to deposit additional cash or acceptable collateral. If you fail to meet your minimums, your broker may be forced to sell some or all of your securities, with or without your prior approval.

Potential benefits of short selling mostly revolve around the possibility (not guarantee) of early and out-sized profits. While there is always the chance for a huge loss, there is also the chance of a considerable gain should the stock price tumble significantly. When combined with buying on margin (borrowing money to buy stock), the potential for a high return on investment (ROI) with less or lower initial capital can seem very attractive. However, short selling may be used to attempt to offset risk in some cases. More experienced investors sometimes use it as a short term hedging tactic (a method intended to manage investment risk) to offset the risk of another investment.

Even if you are not planning on short selling a stock, knowing if others are short selling it can be an insight into the expectations others have for stock.

There are two main ways to know if others are shorting a stock. These are the short interest ratio and the days to cover ratio.

1. Short interest ratio: The short interest ratio (SIR), sometimes called the short float, compares the number of stock shares currently shorted and the number of stocks available on the market. If the SIR is high, there are a lot of shorted stocks compared to the available stocks — a sign that the stock is likely considered overvalued by other investors.
2. Days to cover ratio: Days to cover ratio, sometimes called short interest to volume ratio, compares the average daily trading volume of stock to the outstanding shorted shares. It tries to show how many days it would take to cover all the outstanding shorted shares at the average trading volume. Like SIR, a high day to cover ratio generally indicates a general market opinion that the stock is likely considered overvalued by other investors.

In general, yes, short selling is legal. However, short selling for the purposes of manipulating the market is not. Far too many possibilities of this type of manipulation exist to list them all, but there are two common examples. Short selling (usually in a series of short sales) to create extra activity on a stock or the illusion of it falls into the prohibited category. Also noted by the SEC, using short sales to influence others to buy or sell that stock also falls under the prohibited umbrella.

Naked short sales occur when the investor who is selling the stock short is unable to deliver the borrowed shares they traded within a required 2-day timeframe for stock settlements. A naked short sale doesn’t always mean that something illegal or shady happened. A computer glitch, paperwork error, mistakenly issuing physical certificates instead of electronic ones, and other problems could all be legitimate issues affecting the availability of the delivery of shares on schedule. Non-delivery of the promised borrowed stocks is called failure to deliver or “a fail.”

Before using margin, customers must determine whether this type of trading strategy is right for them given their specific investment objectives, experience, risk tolerance, and financial situation. Margin borrowing increases your level of market risk, as a result it has the potential to magnify both your gains and losses Regardless of the underlying value of the securities you purchased, you must repay your margin loan Your broker can change their maintenance margin requirements at any time without prior notice. If the equity in your account falls below the minimum maintenance requirements (varies according to the security), you’ll have to deposit additional cash or acceptable collateral. If you fail to meet your minimums, your broker may be forced to sell some or all of your securities, with or without your prior approval. For more information please see Robinhood Financial’s Margin Disclosure Statement, Margin Agreement and FINRA Investor Information. These disclosures contain information on Robinhood Financial’s lending policies, interest charges, and the risks associated with margin accounts.