What is short selling and why do investors do it?
For experienced traders and sophisticated investors, short selling can provide an opportunity to capitalize on falling markets. Investors use short selling when they feel that a company or sector is overvalued, with a view to profiting when its stock price drops.
However, short selling is an involved, potentially time-consuming investment strategy. And while it can certainly bring big returns, it can also result in big losses.
How does short selling work?
When you go short, you expect a stock price to decrease. You borrow the stock from your broker’s inventory, the shares are sold, and proceeds are credited to your account.
At some point (ideally when the value has decreased considerably) you buy back (or “cover”) the same amount of shares and return them to your broker. If the stock has fallen, you make a profit; if it has increased, you lose money.
What you need to sell short
Given the added risks involved, you will need to apply and be approved for short selling. You trade from a margin account into which you will have to deposit the full cost of the short sale shares plus anywhere between 30 – 100 percent of the value of your position as a margin deposit. If the stock price rises, you may have to add money to your account in what is known as a margin call.
There are several costs involved in short selling: trading commission, potential margin interest, and any dividends, distributions or rights declared during the period of the loan.
How you can win, how you can lose
You will make a profit if the selling price is considerably lower than your buying price. Let’s say you short 1,000 shares in Company Z at $25 per share. After two months you buy it back after shares sink to $5. Your gross profit is $20 ($25 - $5) x 1,000 = $20,000. You would then have to subtract your costs as described above, to calculate the net profit.
However, if those same shares were to rise in value, to $90 per share, your loss would be $65 ($90 - $25) x 1,000 = $65,000.
While your gains can only ever be as high as 100% of your investment, your losses can, in theory at least, be unlimited.
The pros of short selling
It is possible to make a lot of money by short selling because stocks and markets tend to fall much faster than they rise. Short selling can also be a useful tool for hedging portfolio risk—investors can protect their long-term investments by offsetting short positions.
The risks of short selling
You can stand to lose a lot of money. Sometimes you may be forced to buy back the stock early, known as being “bought in”. This can happen when the lender asks for the stock to be returned to sell it on or they force the position to be closed if they become worried that heavy losses make it less likely that the shares will be returned. This happens very rarely, however.
If a stock with very high short interest surges in price, it creates a short squeeze, which can force short sellers to close out their short positions, often at a loss.
Regulators may also impose bans on short sales in certain sectors or markets to avoid panic, leading to unexpected losses.
To succeed, short sales must be well-timed. You may be right about a company’s worth dropping but your timing must still be right. This dependency on timing means you have to keep a close eye on your positions. Day traders are in a good position to use a short selling strategy, because their activity level enables them to make quick trading decisions that make money or minimize losses. Of course, you don’t have to be a day trader to use a short selling strategy, but you should make sure you have the time to actively monitor your positions.