Short Selling

Understanding Short Selling: Key Points You Should Know

Short selling, or “shorting,” is a tactic employed by investors to make money from the fall in the price of shares or other financial instruments. It is advanced trading strategy and involves a very high risk, but if done properly, can yield huge returns. In this blog, we shall discuss what short selling is, how it is done, its risk, and important points to note prior to participating in this investment strategy.

1. What is Short Selling?

• Short selling refers to the act of borrowing a stock’s shares or other assets from a broker, selling them at the prevailing market price, and subsequently buying them back later at a lower price. The aim is to purchase the shares at a lower price to return to the lender, thereby making a profit out of the difference.
• Short selling is different from conventional investing, in which the investor purchases shares hoping the price will go up. Short selling is done under the expectation that the asset will decrease in value.

2. How Short Selling Works

There are some key steps in short selling:

• Borrowing Shares: The investor borrows the shares of a stock from a brokerage company, which often holds the shares in its inventory or acquires them from other investors.
• Selling the Shares: The borrowed shares are sold at prevailing market price. For instance, if a share is quoted at $100, the investor offloads the borrowed shares at such price.
• Purchasing Back the Stocks: Once the stocks are sold, the investor waits for the price to decline. When the price declines as anticipated, they can purchase the same quantity of stocks at a lower price. For example, if the price declines to $70, the investor buys back the stocks at this price.
• Returning the Shares: The investor hands over the borrowed shares to the broker, and the gain is the difference between the sale and repurchase price. For instance, if the investor had sold the shares at $100 and repurchased the shares at $70, the gain would be $30 per share.

3. The Mechanics of Short Selling

• Margin Account: For short selling, an investor should have a margin account with a broker. Through this account, the investor is able to borrow money or stocks from the broker. The investor is usually required by the broker to keep a minimum balance in the account, referred to as the margin requirement.
• Collateral: Investors need to put up collateral when engaging in short selling, which is used as collateral for the broker. Collateral can be either in cash or securities and assures the broker that the investor is able to purchase the borrowed stocks if necessary.
• Margin Call: In the event that the stock price appreciates rather than declines, the investor would be required to maintain the position by putting more money into the margin account. The process is referred to as a margin call. If the investor fails to meet the margin call, the broker can close out the position, leading to a huge loss.

4. Risks of Short Selling

Short selling does carry its share of risks, and it’s important that investors learn these risks prior to going in on the strategy:

• Unlimited Potential for Loss: The main risk of short selling is that the potential for loss is unlimited. Whereas the stock price can only decrease to zero, there is no limit on how high the stock price can go. If the stock price rises dramatically, the investor will have to buy back the shares at a significantly higher price than they sold them for and incur huge losses.
• Short Squeeze: A short squeeze is the phenomenon when a heavily shorted stock’s price starts to move upwards, prompting short sellers to cover their shorts in order to contain their losses. This short covering leads to an increase in price even more, which makes it a self-sustaining process that can lead to enormous losses for short sellers.
• Borrowing Costs: Investors are required to pay borrowing charges to brokers while short selling, and such charges can be considerable, particularly for difficult-to-borrow stocks. In a few instances, the cost of borrowing shares may turn out to be more than the profits from short selling.
• Dividend Payments: If a stock shorted will pay dividends, the short seller must pay out the dividends to the lender. This is an additional cost of the short sale and brings down the potential profits further.

5. Why Investors Short Sell

Although there are risks, there are various reasons why investors short sell:

• Profit from Falling Markets: With short selling, investors can make a profit in falling markets or from the fall in the value of a particular stock. This can be especially helpful during bear markets, when most investments are seeing a general drop in their worth.
• Hedge Other Investments: Investors can employ short selling as a hedge against other investments in their portfolio. For instance, if an investor is long on stocks but expects that a specific industry will perform worse, they may short sell shares in that industry to hedge against losses in their portfolio.
• Market Efficiency: Short sellers contribute towards maintaining market efficiency by adding liquidity and helping to discover prices. By short selling overvalued stocks, short sellers can get attention for those companies whose price levels do not represent their inherent value, therefore keeping prices according to fundamentals.

6. Example of Short Selling

Following is an example of short selling:

• An investor feels that Company ABC’s stock, which is currently selling at $100 per share, is overpriced and will fall. The investor borrows 100 shares of ABC from a broker and sells them at the prevailing market price of $100 per share, earning $10,000 from the sale.
• After a few weeks, the share price drops to $70 per share, as forecasted by the investor. The investor buys back the 100 shares for $7,000 and returns them to the broker.
• The investor earned a profit of $3,000 ($10,000 from selling the shares – $7,000 for buying back the shares).
• In this instance, the short sale was successful, and the investor made a profit. But if the price of the stock had increased rather than decreased, the investor would have incurred a loss.

7. Regulations Governing Short Selling

Short selling is regulated in most countries, and the regulations are intended to safeguard market participants and maintain fair trading. Some of the most important regulations are:

• Uptick Rule: In certain markets, the uptick rule limits short selling to when the stock price is increasing or flat, with the purpose of avoiding excessive downward pressure on stocks.
• Short Sale Reporting: Certain nations mandate that investors report large short positions or offer transparency on short interest levels so other market participants are informed of the extent of short selling in the market.
• Restrictions in Times of Crises: In times of high market volatility or crises, regulators can impose short selling bans for a limited period to avoid excessive downward pressure on share prices, which may trigger panic selling.

8. How to Reduce Risks in Short Selling

Investors who opt for short selling can follow a number of steps to reduce risks:

• Employ Stop-Loss Orders: A stop-loss order will assist in capping potential losses by permitting automatic purchase of the shares if the price goes up to a specified point.
• Diversify: Diversifying short positions among several stocks or industries can distribute risk and lower the effect of any single bad trade.
• Watch the Market Carefully: Short selling demands a close watch of the market. Investors must observe news, earnings announcements, and other factors that may affect the stock price.