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 The term short-selling stock refers to the practice of selling securities that you do not own. Investors will short-stocks when they believe a stock's market price is going to decline. The process of short selling involves borrowing stock from a brokerage house to sell in the stock market. At a future date, you repurchase the borrowed stock and that step in the process is called a "short cover."
In this article, we're going to cover the stock market investment strategy referred to as short selling. We'll explain the four steps involved when selling a stock short, as well as the risks and rewards involved with this type of investment approach. We'll talk briefly about some specialty short-selling approaches such as "naked shorts" and "shorts against the box." Finally, we'll finish up with a couple of examples.
Selling Short
When an investor is selling a stock short, they have a negative or "bearish" outlook with respect to the price of the stock they're trading. Day traders and hedge fund managers will often sell-short in an attempt to profit from falling prices on securities they believe are overvalued.
Stock exchanges will typically report the total number of shares of a security that have been sold-short by investors and that have not been repurchased to settle short positions in the market - this is referred to as short interest. The short interest ratio is calculated by taking the monthly short interest on the entire stock exchange and dividing it by the average daily trading volume. A high short interest ratio typically indicates bearish feelings towards the market.
On the other hand, bullish investors see a high short interest ratio as positive sign for the market's outlook. These investors believe that short interest positions must eventually be covered, and the increase in demand for stocks necessary to cover open positions will drive the price of stocks back up.
How Selling Stocks Short Works
The process of selling stocks short consists of the following four steps:
- The investor borrows shares of the stock they are going to short. This step is often accomplished using cash on deposit with a brokerage firm that can be used as collateral. The difference between buying and borrowing a stock is subtle but worth understanding. When an investor borrows stock, they're promising to give back the stock a future point in time.
- The stock that is borrowed is then sold, and the proceeds from the sale are deposited into the investor's brokerage account.
- The investor patiently waits for the price of the stock to drop and then closes their position by buying back the shares - which is called covering their short position.
- The investor returns the borrowed shares back to their broker or lender.
Making Money Selling Short
The investor profits from this strategy when the price of the stock they're borrowing declines. These investors have a negative outlook on the security and anticipate the price of the stock will fall. In fact, "selling-short" is the opposite of "going-long," and normally when the short seller borrows stock, the broker they're working with borrows the stock from an investor that is taking a long position.
In the United States, short-sellers must ensure that their broker is able to make delivery of the securities. This is referred to as "locate" and brokers will not allow customers to short a stock before assuring that shares can be borrowed.
Naked Shorts
Naked short selling or "naked shorting" is the practice of selling a stock short without first borrowing the shares or making an "affirmative determination" that the shares can be borrowed. The practice of naked shorting, with the intent to drive down share prices, violates US securities law. In January 2005, the SEC enacted Regulation SHO to reduce the practice of naked short sellng and the subsequent practice of "failure to deliver" securities.
Shorting Agains the Box
"Shorting against the box" occurs when an investor sells-short securities that they already own. The name is derived from the thought of selling-short the same securities that are held in a safe deposit box.
The strategy behind this approach is to lock-in "paper" profits on the investor's long position without having to sell the stock. If the price of the stock held by the investor increases or decreases, then the profits, or loss, on the short position are offset by the profit, or loss, on the long position.
The IRS views "shorting against the box" as a "constructive sale" of a long position, which triggers a taxable event unless certain conditions are met.
Risks Associated with Selling Stocks Short
Since the investor selling-short is hoping that the price of the borrowed security will fall, the biggest risk to taking this position is that the price of the stock increases. If that occurs, and the investor is using a margin account, then a margin call will be made if the required maintenance is not met. This can occur when the stockholder's equity position falls below a prescribed percentage.
If the price of the stock remains at a depressed level, then the short-seller may eventually be forced to close out their position and realize a loss on the transaction. Since there is no theoretical upper limit to a stock's price, the investor's loss is also without theoretical limits. But since the price of a stock cannot fall below $0 / share, the upper limit for profit is the total value of the stock sold short.
Stop Loss Orders
One strategy that traders use to limit their losses when shorting stocks is to place a "stop loss order." When you short a stock, you can issue what is called a stop-loss buy order at a set price. The order will be executed if the stock's price reaches the stop-loss price. When this happens, you've closed out your short position on the stock, thereby placing a limit, or cap, on your loss.
Short-Selling Example
In this example, a short-seller is looking to borrow 100 shares of Company X stock currently selling at $50 per share. The seller borrows the 100 shares of Company X from their broker and immediately sells the shares on the market for $50 per share x 100 shares or $5,000.
Let's assume that at a future point in time the price of Company X stock drops to $40 per share. The short-seller would then buy back the 100 shares of Company X at $40 per share or $4,000 and make $1,000 in profit.
The theoretical limit of profitability in this example occurs if the price of Company X's stock falls to $0 per share. At that point, the short seller purchases the stock of Company X for $0 and makes a profit of $5,000.
On the other hand, if the price of Company X's stock were to rise to $1,000 per share (not probable, but possible), then the short seller would be forced to pay $1,000 per share x 100 shares or $100,000 and realize a loss of $95,000 on the transaction.
About the Author - Short Selling Stocks
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