What is Short Selling?

Short selling involves betting on a decline in the price of a particular security, such as a stock. It is a technique that is typically used by more experienced traders or investors and carries the possibility of substantial risk. As such, it is generally considered to be an advanced investment strategy.

Traders may use short selling to speculate on market movements, while investors or portfolio managers may use it as a way to protect against potential losses on other investments. This technique, known as hedging, involves placing offsetting positions to reduce risk exposure. Speculative short selling, on the other hand, carries the possibility of substantial risk and is generally considered an advanced trading method.

In short selling, an investor borrows shares of a stock or other asset that they believe will decrease in value, and sells these borrowed shares to buyers at the current market price. The investor is betting that the price of the asset will continue to decline, and they will be able to buy the shares back at a lower price before they need to be returned. However, the potential loss on a short sale is theoretically unlimited, as the price of any asset could potentially rise indefinitely.

Understanding Short Selling

Short selling involves borrowing shares from a broker or dealer and selling them on the market with the hope of buying them back at a lower price in the future. The goal is to profit from the decline in the price of the security. To close the short position, the trader must buy the shares back on the market and return them to the lender or broker. It is important for traders to consider any interest charges or commissions that may be incurred on the trade.

To engage in short selling, a trader must have a margin account and typically must pay interest on the value of the borrowed shares while the short position is open.

Brokers handle the process of finding shares to borrow and returning them at the end of a trade behind the scenes. Trades can usually be opened and closed through regular trading platforms with most brokers. However, each broker may have certain requirements that a trading account must meet in order to allow margin trading, such as short selling.

Why Sell Short?

The primary reasons for engaging in short selling are speculation and hedging. A speculator is making a bet on the future price of a security, hoping to profit from a decline. If their prediction does not come true, they will have to buy the shares back at a higher price, resulting in a loss. Short selling carries additional risks due to the use of margin and is typically conducted over a shorter time horizon, making it more likely to be used for speculation purposes.

Short selling can also be used as a way to hedge a long position, such as by selling short against call options to lock in profits. It can also be used to limit potential losses on a long stock position by selling short in a security that is closely related or highly correlated with it.

Short selling example

Suppose a trader believes that XYZ stock, which is currently trading at $50, will drop in price within the next three months. The trader borrows 100 shares and sells them to another investor. The trader is now "short" 100 shares, as they have sold something that they did not own but had borrowed. The short sale was only possible because the trader was able to borrow the shares, which may not be possible if the stock is already heavily shorted by other traders.

A week after the short sale, the company whose shares were sold reports poor financial results, causing the stock price to fall to $40. The trader decides to close the short position by buying 100 shares on the open market at this new price in order to replace the borrowed shares. The trader's profit on the short sale, before considering commissions and interest on the margin account, is $1,000 ($50 - $40 = $10 x 100 shares = $1,000).

Short selling as a hedge

In addition to speculation, short selling can also be used for hedging purposes, which is generally seen as a lower-risk and more reputable use of the technique. The main goal of hedging is to protect against losses or preserve gains in a portfolio, rather than seeking profits as the primary motivation. However, hedging can come at a significant cost, so most retail investors do not typically consider it in normal market conditions.

Hedging comes with two types of costs. There are the actual expenses associated with implementing the hedge, such as the fees for short selling or the premiums paid for protective options contracts. In addition, there is the opportunity cost of potentially limiting the potential upside of a portfolio if markets continue to rise. For example, if 50% of a portfolio that has a strong correlation with the Standard & Poor's 500 Index (S&P 500) is hedged, and the index goes up 15% over the next 12 months, the portfolio would only see approximately half of that gain, or 7.5%.

Pros and Cons of Short Selling

Short selling can be expensive if the seller is incorrect in their prediction of the price movement. When someone buys a stock, they can only lose the full amount of their investment if the stock falls to zero. However, if someone shorts a stock, they can potentially lose more than 100% of their original investment. This is because there is no limit to how high a stock's price can go, and it can potentially rise indefinitely. Additionally, traders must fund their margin account while the short position is open, and they must factor in the cost of margin interest when calculating their profits, even if the trade is successful.

Pros

• Short selling has the potential to generate high profits.
• It requires a relatively small amount of initial capital.
  
• It allows for the use of leverage in investing.
  
• It can be used to hedge against other holdings.

Cons

• Short selling carries the risk of potentially unlimited losses. 
• It requires the use of a margin account. 
• Margin interest is incurred while the short position is open. 
• It is vulnerable to short squeezes, which can drive the price of the security higher and increase losses.

When a short seller wants to close their position, they may face difficulty finding enough shares to buy if there are many other traders also shorting the stock or if the stock is not heavily traded. On the other hand, they can also get caught in a "short squeeze" if the market or a particular stock suddenly experiences a significant price increase. This can drive the price of the security higher, leading to increased losses for the short seller.

While high-risk strategies come with the potential for high rewards, they also carry the risk of significant losses. Short selling is no exception. If the seller correctly predicts the price movement, they can potentially achieve a high return on investment (ROI), especially if they use margin to initiate the trade. Using margin allows for leverage, meaning the trader does not need to put up a large amount of capital upfront. If executed carefully, short selling can be a cost-effective way to hedge and balance out other holdings in a portfolio.

It is generally recommended that novice investors avoid short selling until they have gained more experience in trading. However, short selling through exchange-traded funds (ETFs) is generally considered to be a less risky strategy due to the reduced likelihood of a short squeeze occurring.

What else to consider Selling Short

> Using borrowed money

Short selling involves margin trading, where an investor opens a margin account and borrows money from a brokerage firm using their investments as collateral. Similar to going long on margin, it can be easy for losses to spiral out of control if the account falls below the required minimum maintenance level of 25%. In this case, the investor may be subjected to a margin call and be forced to either add more cash or liquidate their position.

> Wrong timing

Even if a company's stock is overvalued, it may take some time for the price to decline. During this period, the investor who has shorted the stock is at risk of incurring interest and margin calls, and they may be required to close the position before they are ready.

> Short Squeeze

A stock that is heavily shorted, with a high short float and a high days-to-cover ratio, may also be at risk of experiencing a short squeeze. A short squeeze occurs when a stock starts to rise in price, causing short sellers to buy back or "cover" their positions. This buying can create a feedback loop, where increased demand for the shares attracts more buyers, pushing the price of the stock higher and causing more short sellers to cover their positions.

> Regulatory Risks

Regulators may put restrictions on short selling in a specific industry or the overall market to prevent panic and excessive selling pressure. These measures can lead to a sudden increase in stock prices, causing short sellers to incur significant losses as they are forced to close their short positions.

> Going Against the Trend

In general, stocks tend to trend upwards over time. Most stocks appreciate in value over the long term, even if a company's performance is only slightly better than inflation. This means that short selling is betting against the overall direction of the market.

Costs of Short Selling

In addition to the standard trading commissions that must be paid to brokers, short selling also involves a number of other costs. Some of these costs include:

> Margin Interest

Margin interest can be a significant cost when trading stocks using margin. Since short sales can only be conducted through margin accounts, the interest payable on short trades can accumulate over time, particularly if short positions are held open for an extended period.

> Stock Borrowing Costs

Shares that are hard to borrow due to high short interest, a limited float, or other reasons may carry "hard-to-borrow" fees that can be substantial. These fees are based on an annualized rate that can range from a small fraction of a percent to more than 100% of the value of the short trade, and they are prorated based on the number of days that the short position is open.

The hard-to-borrow rate can vary significantly from day to day, and even on an intraday basis, so the exact dollar amount of the fee may not be known in advance. The fee is typically charged to the client's account by the broker-dealer at the end of the month or when the short position is closed. If the fee is substantial, it can significantly impact the profitability of a short trade or exacerbate losses.

> Dividends and Other Payments

The short seller is responsible for paying dividends on the shorted stock to the entity from which it was borrowed. They are also required to make payments in the event of other occurrences related to the shorted stock, such as share splits, spinoffs, and bonus share issues, which are often unexpected.

Short Selling Metrics

There are two metrics used to monitor short-selling activity on a stock:

• The short interest ratio (also known as the short float) measures the ratio of shares that are currently shorted to the number of shares available or "floating" in the market. A high short interest ratio is often associated with stocks that are declining or perceived to be overvalued.
• The short interest to volume ratio (also known as the days-to-cover ratio) is the total number of shares held short divided by the average daily trading volume of the stock. A high value for the days-to-cover ratio can be a bearish sign for a stock.

Both metrics used to track short selling activity can help investors understand whether the sentiment towards a particular stock is generally bullish or bearish.

For example, when oil prices declined in 2014, General Electric's (GE) energy divisions started to negatively impact the performance of the company as a whole. The short interest ratio increased from less than 1% to over 3.5% in late 2015 as short sellers began anticipating a drop in the stock price. By mid-2016, GE's share price had peaked at $33 per share and started to decline. By February 2019, the price had fallen to $10 per share, resulting in a profit of $23 per share for short sellers who shorted the stock near the top in July 2016.

Ideal Conditions for Short Selling

Timing is critical in short selling. Stocks typically decline more quickly than they advance, and a significant increase in a stock's value can be wiped out in a matter of days or weeks due to an earnings miss or other negative news. Therefore, short sellers must be precise in timing their trades. Entering the trade too late can result in a significant opportunity cost in terms of missed profits, as much of the stock's decline may have already occurred.

Conversely, entering the trade too early can make it difficult to maintain the short position due to the costs and potential losses that could occur if the stock rises quickly. This could be especially costly if the short seller is using margin to initiate the trade.

There are certain circumstances in which the chances of successful short selling are increased, including:

> During a Bear Market

During a bear market, when the dominant trend for a stock market or sector is downward, traders who believe in the adage "the trend is your friend" have a higher likelihood of successful short selling trades. Short sellers tend to thrive in environments where the market decline is rapid, widespread, and severe, such as the bear market of 2008-09, because they have the potential to earn large profits during these times.

> When Stock or Market Fundamentals Are Deteriorating

There are several factors that can increase the chances of success when short selling. One of these is the overall trend of the stock market or sector, which should be down during a bear market. Short sellers may also have more success when the fundamentals of a particular stock have deteriorated or if there are negative economic or geopolitical developments that could impact the market. Additionally, if a stock has reached new highs on decreasing volume or if there are other bearish technical signals, it may be a good opportunity for short selling.

When it comes to short selling, experienced traders may prefer to wait until a bearish trend is confirmed before entering a trade, rather than making a prediction of a downward move. This is because there is a risk that the stock or market could trend upwards for an extended period of time, even with declining fundamentals, which is often seen during the later stages of a bull market.

> Technical Indicators Confirm the Trend

When bearish trends are confirmed by multiple technical indicators, such as a breakdown below a key long-term support level or a bearish moving average crossover, short sales may have a higher chance of success. This is because these indicators suggest that the stock or market is likely to continue declining in price. In contrast, if a stock or market trends higher for an extended period of time despite worsening fundamentals, short sales may be less likely to be successful.

Conclusion

Short selling is a strategy that allows investors to profit from a decline in a stock's price. To short a stock, an investor borrows shares and sells them, with the goal of repurchasing them at a lower price in the future.

While short selling has been criticized as being against the market, many economists believe that it helps to make markets more efficient and can even act as a stabilizing force. Technical analysts often consider a stock's short interest and other short-related ratios when forming trading ideas.

However, large short positions can be prone to short squeezes, where buying is required to close the position and can drive the price higher, leading to even greater losses for short sellers.