What is Short Selling?
Short selling is an advanced trading strategy where you borrow shares of a stock, sell them at the current price, and hope the price falls so that you can repay the borrowed shares at a lower price.
Short selling occurs when an investor thinks a stock price will fall. He sells borrowed shares at the current price and hopes to repurchase them at a lower price if the value drops. Just like regular stock buys have risk, so does short selling. In fact, short selling has more risks than traditional stock purchases. Investors must be aware of the risk that share prices could rise instead of fall — Resulting in the investor having to spend more to repay the shares than the overall value of the original shares. Plus, they would still have to pay fees associated with the borrowed shares. The potential losses in short selling are theoretically unlimited, since a stock’s price can rise infinitely.
A fictitious investor named John thinks the share price of the fictitious company Watch World is far too high because a competitor is set to release a revolutionary new watch. John uses his margin account and borrows 100 shares of Watch World. He sells the shares at $15 each, the current market rate. Now John has to wait to see what happens with the stock price. The competitor’s watch is a massive hit, and Watch World stock falls 15% to $12.75 per share. John buys 100 shares at $12.75 to repay his broker. Before fees charged on the borrowed shares, John has made $225 by short-selling Watch World.
Short selling is like borrowing money from a loan shark to gamble down at the track…
Not only might you come out on the losing end of your bet in both cases, you also end up owing more than you intended to put at risk.
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.
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.
Sell the shares: Next, the shares of borrowed stock are sold on the stock market.
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.
Close short position: Closing the short position, also called short-covering, means buying shares to replace the borrowed shares.
Reconciliation: If the price of the stock did drop, the investor made a profit; but if the stock price rose, they lost money. Also, once all the buying and selling is done, the profit or loss can be figured. Fees for the trades, fees for borrowing the shares, and other costs are subtracted from any profit of the short sale. Even if the share prices dropped, they 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 activity, 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 quick and large 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 little 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 minimize 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.
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.
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 may fall.
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 mean that the investor who is selling the stock short doesn’t deliver the borrowed shares they traded within a required 3-day timeframe. 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. 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.
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