Would you believe me if I told you that investing in bad companies can make you a fortune? We’re not talking about evil companies here; we’re talking about failing businesses.
Of course, most people would never consider putting their hard-earned money into a business that’s likely to go bankrupt. But short sellers do just that. They trade in stocks that are deemed undesirable or those on the verge of becoming so.
I know it’s a bit perplexing; I mean, how could someone who is betting against their own investment possibly make any profit? Don’t worry, though, because, within a few minutes, I’ll explain the mysteries surrounding short selling and why this dangerous form of stock trading can be so profitable.
Let’s start with the basics: What does it mean when a stock is shorted or simply what is short selling?
In This Article
What is short selling?
In simple terms, short selling is betting against a stock. It’s an investing technique that traders and hedge funds use to make money off of the decline in the price of stocks, specifically those they anticipate will fall in value or become utterly worthless in the near future.
The traditional way of investing involves buying a stock at a low price and waiting to sell it at a profit when the price rises. Short selling, on the other hand, is a strategy that makes you money when a stock or an entire market crashes.
Traders use short selling as a form of speculation, while portfolio and hedge fund managers use it to protect against the downside risk of another long position, a technique known as hedging.
Speculation as a trading scheme is sophisticated and tremendously risky, even for experienced traders. Hedging, on the other hand, is a more common way to offset the risks involved in holding a particular stock.
Read More: When Should You Sell A Stock?
How does short selling work?
Short selling, also known as shorting, is the process of selling securities or other financial instruments that are not currently owned and subsequently repurchasing them at a lower price, thus profiting from the decline of the security.
Here’s how the entire process of shorting works.
When an investor identifies an asset (stock, ETF, index fund, forex pair) that they think will fall in the near future, they approach their stock broker and ask to borrow the asset.
The broker then has to locate the stocks either from their own inventory or from clients who have them in their brokerage accounts and have not lent them out. This is important because an investor cannot short shares that don’t exist, neither can they borrow shares that have already been lent out to another short seller.
This is also to say that if you’re a long-term investor and have shares in a brokerage account, your broker might be earning money from lending out your shares. This information might be disclosed in the terms and conditions.
Once the broker locates and lends the shares to the investor, the investor sells the shares immediately at the current market price.
But remember, anything that’s borrowed has to be returned to its rightful owner. So the investor sits on the sidelines, waiting and hoping that the stock price will plummet so that they can repurchase them cheaply and return them to the stock broker.
If that happens, they stand to make a considerable profit. However, the losses will be massive if the stock price goes up and they’re forced to repurchase them at an even higher price than they bought them.
Read More: What Happens When Interest Rates Rise?
Shorting example: best-case scenario
Say you think a stock A will crash in the next two months. So you borrow ten shares of the company and immediately sell them at $10 each; you’ve just made $100. But remember that you still need to return the borrowed shares, so you wait for the price to drop to repurchase them at a lower price.
Just as expected, the stock plunges to $1, and you buy back the ten shares at a total cost of $10 to return them to your broker. Considering you sold them at $100 and repurchased them at $10, you just made yourself a $90 profit.
Shorting example: worst-case scenario
Using the example above, let’s say the stock’s price action doesn’t go according to plan. Instead of plunging, the stock price skyrockets to $50. Now you have to repurchase the shares at a total cost of $500, making a loss of $400.
But what if you are really convinced that the stock price will eventually fall and you decide to be patient. But once again, the stock skyrockets to $100. You’re now forced to buy the shares at a total cost of $1000, making a loss of $900.
As you can tell by now, this could go on indefinitely, and the amount of loss you can make is limitless.
In contrast to long-term buying and holding of stocks and other assets, short selling incurs hefty charges that must be paid to brokers. The following are some of the costs:
Interest on Margin
The key to shorting a stock is borrowing shares from somebody else, mostly a stock broker. Therefore, in order to short a stock, an investor must have a brokerage account, specifically, a margin account, and there are costs related to this kind of account.
A margin account is a type of account that helps an investor use leverage (borrowed money) to invest, meaning they’ll only have to put a small amount of their own money as initial investment capital. The broker then loans them the rest of the funds, referred to as ‘margin.’
Sounds great, right? When perfectly executed, an investor stands to make a lot in profit using borrowed money. But there’s a caveat, though; they have to pay interest on the margin.
So in the case of short selling, the longer you keep your short position open, the more your interest charges accumulate.
Trading fees, also known as trading commissions, are fees charged every time you execute a trade. That means whenever you buy, sell or short a stock or an ETF, you pay a certain percentage of the transaction to your broker.
There’s a finite number of stocks that can be shorted.
A security can be easy or difficult to borrow depending on the amount of float available (the number of shares available for investors to trade) and its short interest (the number of shares already shorted).
Earlier, I mentioned that a stock broker must find the shares needed before lending them to an investor for shorting.
The stock broker will charge a high ‘hard-to-borrow’ fees if a security is already highly shorted.
These fees can add up quickly because they fluctuate day by day and are charged for each day a short trade is open.
What are the risks of short selling
When done correctly, short selling can be lucrative, but it comes with more risks than what typical stock investors face.
Short selling is risky mainly because the potential losses are unlimited, yet the profits you can earn are limited.
In traditional investing, the most you can lose when you buy a stock is the amount you paid for it. If the stock loses all its value and drops to zero, you’ll lose all the money you invested but not more than that. However, if the stock skyrockets, there’s no ceiling for the stock’s price and, therefore, no limit to how much profit you can make.
With short selling, on the other hand, it’s the exact opposite. There’s a limit to how much profit you can make, but your potential losses are limitless.
There are rules pertaining to the minimum amount you should have in a margin account. This minimum amount is also known as maintenance margin and is used as collateral when borrowing money from your broker. Maintenance margin requirement is often 25% of the total value of your investments, but some brokers may require higher amounts.
When you short a security, you use borrowed money, and your broker requires that your account contain assets worth equal to or more than the maintenance margin.
However, if the shorted security starts soaring, you immediately start making losses. These losses could continue until your account slips below the maintenance margin requirements, at which point your broker will demand that you add more personal funds to your account to serve as collateral. This is referred to as a margin call. If you don’t have any money, your broker has the right to sell your assets or close your short positions.
A short squeeze is a situation in which a heavily shorted stock starts to rise in price, forcing those who have shorted the stock to buy shares to cover their positions. This buying demand then pushes the stock price even higher, leading to more significant losses for investors who still have open short positions.
If you believe a particular stock will drop in value and you go ahead and short the stock, it can still take a long time before it actually falls.
At times there’s such a bullish sentiment in the stock market that even if a stock is overvalued, the market might not react to it and may just continue rising.
All this while your short position may be making losses and at the risk of being margin called. You might even end up closing the short position.
So, what does it mean when a stock is shorted?
When a stock is shorted, it means investors no longer have faith in the company, or for whatever reason, they believe that the stock price will fall. Investors can short a stock for many reasons, some of them being:
- There seems to be evidence of suspicious activity associated with the stock or the company.
- Shorting can also occur when so-called “whale” traders decide to cash out their positions in large blocks leading to even more sell-outs, and traders see an opportunity to ride the wave down.
- Investors also short a stock when they believe that an event that’s coming up could lead the drop in price of a security (such as an upcoming quarterly earnings report)
The Pros and Cons of Short Selling
On the other hand, the major con of short selling is its risk. When you short a stock, you are essentially betting that the stock will go down in price. This can be risky, especially if the stock happens to go up in price instead. Additionally, you may have to cover your shorts if the stock price rises too much, which can lead to significant losses. Lastly, if you short a stock, you are usually required to pay interest on the money that your broker lent you to be able to sell it.
- Make profits when markets fall
- Protect your portfolio by hedging
- Little initial capital required
- Make money using borrowed money
- Potential losses are limitless
- There's a ceiling on potential profits
- Margin interest costs
- Short squeeze possibilities