Short Selling - Explanation For Shorting Stocks

Posted on Monday, July 16th, 2018 MarketBeat Staff

Many people invest in stocks with firm convictions that prices will move up because of improving market conditions and the productivity of companies. However, that does not mean that all stock prices are continually rising.

Stocks do suffer from poor business plans, increased competition, and lousy management, among other reasons. It is during these downturns that some traders will employ a strategy with the aim of taking advantage of an upcoming decrease in a stock’s price. This trading strategy is called short selling.

What is Short Selling?

Short selling refers to the sale of security such as a stock, in anticipation of prices falling. The trading strategy is motivated by the belief that the prices of a security will drop, providing an opportunity for the stocks to be repurchased later and for the difference in price to be taken as profit.

Short sellers borrow shares of stocks they don’t own and try to sell them at current price with the aim of rebuying them once the price drops significantly. The aim of this strategy is to benefit from the difference between the price of short selling and the cost of rebuying the stocks.

Unlike investors who hold stocks for their value and the income they produce, traders capitalize on an anticipated decline in price by trying to sell high and buying low. Short selling is most of the time limited to margin accounts because of the unlimited losses that can come into being if stock prices start rising rather than dropping.

Short selling is one of the most misunderstood strategies in investing as short sellers are generally reviled for trying to benefit from a bad situation. After all, a short seller could end up profiting from the woes of a company even while company stockholders’ and employees’ livelihoods are being destroyed.

However, that is not a complete and fair view of the job of a short seller. Optimism in the market can drive prices to lofty levels that are unsustainable and that don’t reflect the actual value of a company. The presence of short sellers in the marketplace can help to rebalance stock prices to ensure that companies are fairly valued.

Short selling also provides a form of defense against financial fraud by bringing to light companies that have tried to inflate their performance and valuation. If all stockholders could profit from a stock’s value rising, but no one could profit from the stock’s value falling, there would be very little pressure keeping the stock’s price in line with reality.

How Short Selling Works

Short selling involves three clear-cut steps. For starters, a trader with strong conviction that a stock price is destined to trade lower would borrow shares of that security from a broker. Once a request to borrow the shares is accepted, the trader will sell the shares at the market price.

If the analysis was accurate and the stock price drops from the sale price, the trader will be able to buy the same number of shares back at the new, low market price, then sell them back to the broker at the originally agreed upon value. The trader will profit the difference between the share price at the time of borrowing the shares and the share price at the time of returning the shares.

For example: If Mr. Trader expects the stock of company XYZ, currently priced at $25, to fall in future, he will call a broker and ask the broker to find him 100 shares of the company to borrow for a short sale. As soon as the broker lends the stocks, Mr. Trader sells them all for $25 each. Now Mr. Trader has $2500 but owes his broker 100 shares of XYZ.

If all goes as Mr. Trader hoped, and the share price drops $20, he will be able to cover his short position by buying back the stock. Mr. Trader now spends $2,000 to repurchase the shares and return them to the broker he borrowed them from.

Once the transaction is complete, the profit on the trade will be $500.

Why Do People Engage In Short Selling?

Traders engage in short selling when they speculate that a stock price will fall as a response to a changing market or a company’s fundamentals.  Speculation is the main reason behind short selling, especially on companies that investors feel are overvalued. Solid research, good intuition, and excellent timing are all required if one is to profit from speculation.

However, some traders also engage in short selling as a way of hedging a long position in the same or similar stocks. Some traders also participate in a short sale as a way of seeking favorable tax treatment.

Understanding Short Interest

Short sellers track two key metrics when deploying short selling to generate returns from the stock market: short interest and short interest ratio. Traders can determine the percentage of company’s shares that are being sold short, by first checking ‘short interest.’

Short interest refers to the total number of shares sold as a percentage of a company’s total outstanding shares. If a stock has a short interest of 10%, then it means that for every 10 outstanding shares, one is held as a short. Stocks with high short interest are usually at risk of “short squeeze,” a phenomenon that is most of the time associated with unexpected upward price spikes.

Hedge Funds are the most active when it comes to short selling stocks. Such funds try to hedge the market by short selling stocks they believe are overvalued. Sophisticated investors are also involved in short selling as they try to hedge market risk. Short selling is an ideal trading strategy for traders who think short term as it requires people to keep a close eye on trading positions.

Never short a stock that is likely to draw in a takeover offer. Takeover offers often send prices soaring, which leads to spiraling losses in short positions. It is also important to be cautious when shorting a stock just because it feels overvalued. A stock that feels overvalued can continue rising.

Short selling provides a way for traders to benefit when a company’s fundamentals change, leading to a slide in share price.  Taking into consideration the forces of demand and supply, for a market to remain balanced, there is always a need for people to be on both sides of the trade. It is for this reason that short sellers exist alongside buyers or long traders.

Is short selling risky?

While a necessary part of the market, short selling also has its fair share of risks. For starters, when a large number of traders enter short positions, the collective actions could result in a dramatic impact that would drive prices to levels never seen before.

It is for this reason that regulators at times ban short selling in a bid to protect stocks of companies under pressure.  During the financial crisis, investors were barred from short-selling stocks of banks and other financial institutions.

Short selling can also lead to unlimited losses in the event that stock prices rise instead of fall as expected.  An unexpected spike in prices will force short sellers to cover their positions at once. All traders who have shorted the stock are scrambling to buy the stock back quickly before the price goes even higher. With such high demand, those who hold the stock assume full control and the stock price rises far beyond its true value. Short sellers who fail to cover their positions fast enough can end up with huge losses.

Short selling is riskier than traditional stock buying, in part because it exposes traders to theoretically infinite risks. When shorting a stock, the maximum gain is capped at 100% of the original investment - the best case scenario for a short seller is that the stock goes all the way to zero and the short seller pays nothing to pay back the stocks he owes. On the other hand, the potential losses are unlimited. The worst case scenario is that the stock price suddenly climbs to a million or so dollars before the short seller is able to buy the necessary shares back, and the short seller is deep in the hole forever. Timing is thus important when it comes to short selling, as placing a trade at the wrong time could be a recipe for disaster.

Unlike stock buying, short selling also does come with a number of costs that can eat into one’s returns significantly. For starters, short sellers are normally charged stock borrowing costs that, in worst case scenarios, can exceed the profit from the short trade, especially when dealing with stocks that are difficult to borrow.

The fact that short selling is done in margin accounts also means traders must pay for margin interest on positions taken. Short sellers also must turn over any dividends and distributions paid on borrowed stock. If the trader isn’t careful, the costs can bite out trading gains.

How Day Traders Go About Short Selling

To be able to engage in short selling one first needs to open and finance a margin account. The standard margin requirement is 150%, which means one must set aside 50% of the value of the stock at the time of borrowing in that account. For example, if one wishes to short sell 100 shares of a company going for $10 a share, one will need about $500 in a margin account.

Stock Identification

Short sellers use screening tools to identify potential short candidates whose price might have run ahead of fundamentals and are destined to trade lower.  Stocks with prices hitting lower lows at higher volume, signify that sellers are running the show, which implies possible further movements on the downside.

Stocks that have rebounded considerably from a downtrend also provide short selling opportunities especially if they are trading in overbought territory.  While in overbought areas, stocks tend to lose upward steam providing a chance to profit on the price plummeting back to the lows.

Protect the Order

Once a short position is triggered in a stock, implementing a kind of protection on the order is ideal. In this case, a buy stop order or a trailing buy stop order can come into play as a way helping manage a potential loss, especially during a short squeeze. A short squeeze happens when there is a lack of supply to cover the excess of demand for a particular stock. Short sellers are then forced to cover their positions, resulting in an uptick in buying volume and therefore a higher price for the stock.

A buy stop order is used to trigger a market order to buy back shares once the price rallies back to the stock price entered.  A trailing buy stop order, on the other hand, adjusts the trigger price for taking profits as the stock price moves lower.

Caution

Caution is of utmost importance especially for people who are short selling while using leverage. While leverage is not a bad thing, one still faces the risk of losing more than what is in the account on a stock price going up, rather than down as expected. A stock going up by more than 100% means one can lose more than what is in the account.

While short selling, it is also important to keep track of the catalysts that are pushing and expected to continue driving prices lower. Earnings report are some of the best catalysts for this strategy as they tend to push stock prices in case of a company failing to meet guidance or analysts’ estimates.

Understand the Risks and Costs

Prior to entering a short position and setting up a price at which to buy back the shares, it is important for a trader to take into consideration the costs that come into being in short selling. In case a stock does pay a dividend, a short seller is usually responsible for paying for it back to the stockholder. In addition to margin costs, these costs can significantly reduce one’s potential return and must be taken into account when choosing the price at which to sell and the price at which to buy.

It is also important to look at the total amount of shares in a company, which have already been sold short. Positive news goes a long way in triggering huge price spikes in stocks that have high short interest, as traders usually hurry to buy shares in a bid to cover their short positions.

Bottom Line

Short selling is an important trading strategy that allows traders to profit when the market falls. However, the strategy is suited for traders who are familiar with the risks and regulations involved.

Taking into consideration the risks involved, this strategy is ideal for disciplined traders who know how to cut their losses and cover the losses that they do incur.  The approach is also ideal for people who are willing and ready to handle unlimited risks. Short selling also requires constant monitoring as holding an unprofitable position for long may not be a viable strategy.


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