Shorting a Stock - Short-Term Trading Strategy or Hedge
When shorting a stock trader sells borrowed stock hoping its price will fall and he will be able to by it back at lower price, thus making some profit.
Shorting a stock can be contrasted with the more conventional practice of "going long", with one important difference; investor only profits from any decrease in the price of the asset. When shorting a stock the security isn't owned by the seller, but is promised to be delivered. Your broker will lend it to you from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. The shares are sold and the proceeds are credited to your account.
Sooner or later, you will close your short position by buying back the same number of shares and returning them to your broker. This is called short covering. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money.
Since shorting a stock requires you to have a margin account, you are subject to the margin rules. Other fees and charges may apply. If the stock you borrow pays a dividend, you must pay the dividend to the person or firm making the loan for example.
Why Shorting A Stock?
You would be shorting a stock if this is part of your short-term trading strategy (speculation) or if you would like to protect your existing long positions (hedge).
When you speculate, you are watching for fluctuations in the market in order to quickly make a big profit off of a high-risk investment. Speculators can benefit the market because they increase trading volume, assume risk and add market liquidity. However, high amounts of speculative purchases can contribute to an economic bubble and/or a stock market crash.
Hedging differs from speculating because speculators deliberately assume risk, whereas hedgers seek to mitigate or reduce it. Very few sophisticated money managers are shorting a stock as an active investing strategy, majority of investors use shorts to hedge. This means they are protecting other long positions with offsetting short positions. Hedging can be a benefit because you're insuring your stock against risk, but it can also be expensive and a basis risk can occur.
Specific Short Selling Rules And Regulations
Many restrictions have been placed on the size, price and types of stocks traders are able to short sell. For example, penny stocks cannot be sold short, and most short sales need to be done in round lots. The Securities Exchange Commission (SEC) has restrictions for shorting a stock in place to prevent the manipulation of stock prices.
Naked Short Selling
Modernized rules overseeing short selling aimed to provide safeguards against "naked short selling." For instance, sellers need to show that they can locate and get the securities they intend to short.
The eliminated uptick rule requires that every short sale transaction must be entered at a higher price than that of the previous trade and kept short sellers from adding to the downward momentum of an asset when it was already experiencing sharp declines.
Prohibited Short Selling On Specific Sectors Or Companies
Through the last financial crisis, when markets had been volatile as a result of the mortgage and credit crisis, the SEC wanted to establish a renewed confidence; they prohibited naked short selling on the stocks of 19 major investment and commercial banks.
For Whom Is Short Selling Suitable?
Shorting a stock isn't for everyone! It involves a great amount of time and dedication. Short sellers need to be informed, skilled and experienced investors in order to succeed. They must be familiar with how securities markets work, trading techniques and strategies, market trends and the firm's business operations. Therefore short sellers are typically wealthy sophisticated investors, hedge funds, large institutions, day traders.
Selecting Top Short Picks
Shorter sellers use an endless number of metrics and ratios to find candidates for short sell. Some use a similar stock picking methodology to the longs, but just short the stocks that come out worst. Others look for insider trading, changes in accounting policy, or bubbles waiting to pop.
One indicator specific to shorts that is worth mentioning is short interest. Short interest is the total number of stocks, securities or commodity shares in an account or in the markets that have been sold short, but haven't been repurchased in order to close the short position. It serves as a barometer for a bearish or bullish market. For instance, the higher the short interest, the more people will anticipate a downturn.
An Example Of Shorting A Stock
If your research and analysis is leading you to a conclusion, that a specific ABC company stock is trading far above their fair value and the prospects of the company are really bad, you can predict that stock will trade much lower in the coming months. You decide to short that stock. Let's take a look at how this transaction would unfold.
Step 1: Set Up A Margin Account
In order to begin shorting a stock, you must open a margin account with your brokerage firm. You will be charged interest on the borrowed funds as well as subject to several rules and regulations that govern shorting stock.
Step 2: Place Your Sell Order
If you have setup the right account, the next step of shorting a stock is to enter the order by calling up the broker or entering the trade online. Let's say you decide to put in your order to short 1,000 shares, limit order at $25 each.
Step 3: The Broker Borrows The Shares
The broker, depending on availability, borrows the shares. According to the SEC, the shares the firm borrows can come from the brokerage firm's own inventory, the margin account of one of the firm's clients or another brokerage firm.
Step 4: The broker sells the shares in the open market
The profits of shorting a stock (sale) are then put into your margin account.
Step 5: Buy To Cover The Position
After few months you decide to close your short position. There are two possible outcomes out of your trades:
A. Profit Scenario
B. Loss Scenario
- The stock price sinks to $20
- You have borrowed 1,000 shares of ABC at $25 (total value $25,000)
- You buy back 1,000 shares of ABC at $20 (total value -$20,000)
- Your profit is $5,000
- The stock price rises to $35
- You have borrowed 1,000 shares of ABC at $25 (total value $25,000)
- You buy back 1,000 shares of ABC at $35 (total value -$35,000)
- Your loss is -$10,000
The simplified calculation of shorting a stock above does not account for brokerage fees and other transaction costs or possible company dividend payout in the time of short position in the stock (if you are 'short', you are not the owner of the stock, you have just borrowed it, that is why you actually pay the dividend to the real holder of the stock).
Alternative To Directly Shorting A Stock - Inverse ETFs Or ETNs
An inverse exchange traded fund is an exchange traded fund (ETF), traded on a public stock market, which is designed to perform as the inverse of whatever index or benchmark it is designed to track. These funds work by using short selling, trading derivatives such as futures contracts, and other leveraged investment techniques. By providing, over short investing horizons and excluding the impact of fees and other costs, performance opposite to their benchmark, inverse ETFs give a result similar to short selling the stocks in the index.
S&P 500 Inverse ETF - Example Of Shorting A Stock Alternative
A real example of how inverse ETF works:
An inverse S&P 500 ETF seeks a daily percentage movement opposite that of the S&P. If the S&P 500 rises by 1%, the inverse ETF is designed to fall by 1%; and if the S&P falls by 1%, the inverse ETF should rise by 1%. Because their value rises in a declining market environment, they are popular investments in bear markets.
Inverse ETF Advantages
Shorting a stock has the potential to expose an investor to unlimited losses, whether or not the sale involves a stock or ETF. An inverse ETF, on the other hand, provides many of the same benefits as shorting, yet it exposes an investor only to the loss of the purchase price. Another advantage of inverse ETFs is that you don't need a margin account to go short.
Leveraged Inverse ETFs
Another interesting characteristic of some inverse ETFs is leverage. Leveraged ETF utilizes financial derivatives and debt to amplify the returns of an underlying index. These funds aim to keep a constant amount of leverage during the investment time frame, such as a 2:1 or 3:1 ratio. A leveraged ETF does not amplify the annual returns of an index; instead it follows the daily changes. For example, let's examine a leveraged fund with a 2:1 ratio. This means that each dollar of investor capital used is matched with an additional dollar of invested debt. If one day the underlying index falls 1%, the inverse fund will theoretically return 2%. The 2% return is theoretical, as management fees and transaction costs diminish the full effects of leverage. The 2:1 ratio works in the opposite direction as well. If the index gains 1%, your inverse ETF loss would then be 2%.
Exchange Traded Notes
Exchange-Traded Notes (ETNs) are formally and legally a bit different than ETFs and they also present alternative way of shorting a stock. ETN is a type of unsecured, unsubordinated debt security. This type of debt security differs from other types of bonds and notes because ETN returns are based upon the performance of a market index minus applicable fees, no period coupon payments are distributed and no principal protections exists. ETN is a type of security that combines both the aspects of bonds and ETFs; similar to ETFs, ETNs are also traded on major stock exchanges, but one important factor differs among this two asset classes - ETNs value is affected by credit rating of the issuer. The value of the ETN may drop despite no change in the underlying index, instead due to a downgrade in the issuer's credit rating.
List of most popular inverse ETFs and ETNs
Here is the list of the most popular inverse ETFs and ETNs (as alternative to directly shorting a stock) with links to their official websites.
If there is an instrument missing and you would like us to add it, please contact us.
Shorting A Stock - The Risks!
You have to be aware that shorting can be very risky. You can think of the outcome of a short sale as basically the opposite of a regular buy transaction, but the mechanics behind a short sale result in some unique risks.
Shorting A Stock Is Long-Term Contrarian
History has shown that, in general, stocks have an upward drift. Over the long run, most stocks appreciate in price. For that matter, even if a company barely improves over the years, inflation should drive its stock price up somewhat. What this means is that shorting is betting against the overall direction of the market. So, if the direction is generally upward, keeping a short position open for a long period can become very risky.
Losses Can Be Infinite While Profits Limited To 100%
When you short sell, your losses can be infinite. A short sale loses when the stock price rises and a stock is at least theoretically not limited in how high it can go. For example, if you short 1,000 shares at $25 each hoping to make a profit but the shares increase to $70, you end up losing $45,000, while you invested only $25,000. On the other hand, a stock can't go below 0, so your upside is limited. Bottom line: you can lose more than you initially invest, but the best you can earn is a 100% gain if a company goes out of business and the stock loses its entire value.
Shorting A Stock Requires Margin Trading Account
Shorting stocks involves using borrowed money. This is known as margin trading. When short selling, you open a margin account, which allows you to borrow money from the brokerage firm using your investment as collateral. Just as when you go long on margin, it's easy for losses to get out of hand because you must meet the minimum maintenance requirement. If your account slips below this, you'll be subject to a margin call, and you'll be forced to put in more cash or liquidate your position.
Lender "Call Away"
Most of the time, you can hold a short for as long as you want. However, you can be forced to cover if the lender wants the stock you borrowed back. This is known as being "called away". It doesn't happen often, but is possible if many investors are short selling a particular security.
Short squeezes can wring the profit out of your investment. When stock prices go up short seller losses get higher, as sellers rush to buy the stock to cover their positions. This rush creates a high demand for the stock quickly driving up the price even further. This phenomenon is known as a short squeeze. Usually, news in the market will trigger a short squeeze, but sometimes traders who notice a large number of shorts in a stock will attempt to induce one. This is why it's not a good idea to short a stock with high short interest.
Wrong Timing When Shorting A Stock
Even though a company is overvalued, it could conceivably take a while to come back down. In the meantime, you are vulnerable to interest, margin calls and being called away.
Written by: Goran Dolenc
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