What is Short Selling?

What is Short Selling a Stock?

Short selling stocks is a way to profit from falling stock prices. Although this can prove a profitable trade, it is important to understand that with short selling there is a very real possibility of incurring severe losses. If a stock’s share price recovers it can potentially climb indefinitely, locking you into a process which can destroy your finances.

When short selling a stock an investor is selling a stock that they do not own; they borrow the stock from an investment broker. They then sell the stock and wait until it falls in price.

If the stock price falls they can purchase the stock and close out the short position at a profit – that is, they return the shares to the brokerage they borrowed them from and pocket the difference.

If the stock price rises during the trade the seller can opt to hold a short position until the stock does eventually fall in price, or they can close out the position at a loss.

Shorting is typically done using margin loans that come with interest charges, which have to be paid for as long as the position is in place. The longer the position is open, the more interest charges are incurred, hurting your profits.

What can go wrong?

Simply put, the stock price can rise. The higher the price rises, the more money the investor loses.

No matter how perilous a company’s prospects might seem, there are several factors that might make the stock price rise –

• The stock market could rise significantly, pushing up the price of the shorted stock—despite the weak fundamentals of the company targeted
• The company could announce good news, such as a major contact win, or a positive development in the company’s industry might cause the stock price to rise
• There could be a board-level clear out and a new management team brought in to turn the company around affecting the stock’s price in a positive way
• The company could become a takeover candidate; the announcement of an acquisition or merger could cause the price of the stock to leap
• An institutional investor could take a large position in the stock, deeming that it is undervalued
• Political or economic instability in a certain part of the world might suddenly make the company more attractive
• There could be a change in legislation affecting the company in a positive way

Of course, none of these may happen and the short seller can make a handsome profit, but the markets are unpredictable and unexpected events can and do happen.

Cost Considerations

Margin Interest

When short selling stocks ‘Margin Interest’ can be a significant expense. Short sales can only be made via margin accounts and interest payable can accrue over time, particularly if short positions are kept open over a lengthy period.

Cost of Borrowing Stocks

Some shares can be difficult to borrow for several reasons, for example, high short interest or limited float. These shares have “hard-to-borrow” fees that can be quite considerable. An annualised fee is based on a rate that can range from a fraction of a percent to more than 100% of the value of the short trade and is pro-rated for the number of days that the short trade is open.

The hard-to-borrow rate can fluctuate from day to day (and even on an intra-day basis) so you may not know the exact amount of the fee in advance. The fee is usually issued by the broker to the client’s account at month-end or upon closing of the short trade. If it is quite large it can undermine the profitability of a short trade or make losses even greater.

Dividends and other Costs

The short seller is responsible for making dividend payments on the shorted stock to the body from which the stock has been borrowed. You may also be responsible for making payments on account of other associated events related to the shorted stock - share splits and bonus share issues which can be unpredictable.

Conclusion

Although short selling can be extremely profitable, it is not for the feint-hearted and certainly not recommended for those who lack experience or the finances to be able to suffer a substantial financial loss. Shorting selling is a complex area and much research should be undertaken (even by experienced investors) before considering it as an investing option.

Join Now