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 the 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 an investor who holds 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.
In this article, we’ll help investors understand the process of short selling and help them understand how to use the MarketBeat short interest tracker to identify stocks that may be good candidates for this strategy.
How to Understand the Process of Short Selling with Examples
Short selling is a three-step process with specific actions needed to be taken at each step:
- First, a trader identifies a stock that they believe will trade lower and borrows a quantity of shares of the stock from a broker. Once that request is accepted, the trader sells the shares at the market price.
- Second, if the stock price does fall below the sales price, the trader buys back the equal number of shares at the lower price.
- Third, the trader sells those shares back to the broker at the price the trade initially paid.
The trader profits from the difference between the share price at the time of borrowing the shares and the share price at the time of returning the shares. Let’s look at an example of how this works:
- Trader expects the stock of company XYZ, currently priced at $25, to fall in the future. He calls his broker and asks 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 to $20, he can 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 Traders Engage in Short Selling?
Speculation is the main reason behind short selling, especially on companies that investors feel are overvalued. Companies can suffer from poor business plans, increased competition, and lousy management that may not be accurately reflected in its stock price.
Another reason traders engage in short selling is to hedge a long position in the same or similar stocks. A third reason is to participate in a short sale is as a way of seeking favorable tax treatment. Whatever the reason short selling requires solid research, good intuition, and excellent timing if a trader is to profit from speculation.
With that said, short selling is one of the most misunderstood strategies in investing. 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 to keep the stock’s price in line with reality.
Why Short Interest is a Key Metric for Short Sellers
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 a 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 ratio of 10%, then it means that for every 10 outstanding shares, one is held as a short. Stocks with a high short interest ratio 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.
What Are the Risks Involved With Short Selling?
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 lossesin 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. This is known as a short squeeze. When this happens, all traders who have shorted the stock scramble 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 also comes 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. Also, because short selling is done in margin accounts, 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 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.
- 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 lowsat 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.
- 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 buy stock 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 stock 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.
How to Use the MarketBeat Short Interest Tracker
Investors can use the pull-down menus to screen for specific stocks based on categories such as stock sectors, market capitalization, investor sentiment, and analyst sentiment. Investors can also choose to screen for the largest position which means they can look for the most shorted stocks or the least shorted stocks.
The screener pulls U.S. stocks from both the New York Stock Exchange (NYSE) and the Nasdaq. Along with the stock listing, investors will get an indicator that provides insight as to why the stock has high short interest (e.g. an upcoming earnings report or recent analyst revision).
The Final Word on Short Selling
Short selling is an important trading strategy that allows traders to profit when the market falls. However, the strategy is suited for traders, particularly day 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 for many investors.