Short selling is the practice of borrowing shares from an investor, selling them and then buying them back later. This is a strategy that is designed to profit from a price decline in a security, currency or other financial instrument. The following are illustrative examples.
Profitable TradeA short seller borrows 100 shares of a stock and sells them at $100 for cash of $10,000. The price declines to $40 and the short seller covers the trade by buying 100 shares at this price for a cost of $4000. The short seller's profit is $6000 not including commissions and fees.
Loss-making TradeA short seller borrows 100 shares of a stock and sells them at $10 for cash of $1,000. The short seller holds this position for many months while the stock price increases to $42. The short seller finally covers at $42 at a cost of $4,200 for 100 shares. The short seller's loss is $3,200 not including commissions and fees.
DividendsWhen a short seller borrows shares from an investor that investor is owed any benefits attributed to owning the stock including dividends. For example, a short seller who borrows 100 shares of a stock that issues a $1 dividend must pay $100 to the owner of the stock.
Unlimited LossShort selling is considered a risky and challenging type of trade that is not recommended for anyone except sophisticated entities that understand exactly what they are doing. Markets tend to go up with time and long trades are a safer bet. Even if a stock is overvalued due to investor overenthusiasm, this can persist for many years and an eventual price decline is generally impossible to time. One of the interesting aspects of short selling is that your loss is theoretically unlimited as there is technically no limit to the growth of a company and its stock price. In theory, a stock could go up 10,000% or more in a few minutes.
Margin RequirementsShort selling typically requires a margin account whereby you can borrow money from your broker. This is to cover costs should the stock you short sell go up in price. In order to execute a short trade and hold a short position you must maintain enough money and margin in your account to buy back the shares. It is also common for there to be additional requirements imposed by regulations or the policies of your broker. For example, you may be required to have 150% of the value of a transaction in order to execute a short trade. This would mean that you need $15,000 in order to short sell $10,000 in stock. If you fail to maintain enough margin to conform to the policies of an exchange or broker your broker will issue a margin call that is essentially a demand that you either deposit more money or cover the short trade. Margin requirements mean that short sellers are often forced to cover at a loss unless they are able to maintain enough cash to ride out increases in the price of a stock.
A short squeeze is when short sellers are forced out of a stock due to a price rise, this causes the price to rise more as short sellers purchase shares causing more short sellers to be forced out of the stock in a vicious cycle. A measure known as Days to Cover indicates the number of days of average volume it would take for all short sellers to cover their position in a stock. For example, a stock with 4 million shares short and 1 million in average daily trading volume would have 4 days to cover. A stock with a high days to cover is at risk of a short squeeze.
HedgeA hedge is an investment that is designed to reduce the risk to a portfolio of an adverse price movement. Shorting stocks is one way to hedge a long position in stocks. For example, an investor may invest in stable stocks that are expected to appreciate with time and open a small short position against a firm with an extremely high valuation. This may be done with the hope that if the market crashes, the short position will partially compensate for losses in long positions.
Naked Short SellingNaked short selling is short selling without actually borrowing the stocks from an investor. This is done by selling stocks on the market that a broker doesn't own. The broker then fails to deliver the stocks to the buyer in the expected settlement period. This is known as a failure to deliver. When a failure to deliver occurs, regulations typically kick in that require the seller to provide the stocks within a number of business days. In an environment where stocks are falling rapidly, banks may be tempted to engage in naked short selling. This is typically regulated and is often prohibited, depending on the jurisdiction and market. It is also common for regulators to monitor failure to deliver transactions as a spike in this behavior may be a threat to market health.
ResearchShort selling can benefit markets by giving market participants incentives to identify overpriced securities. In theory, this can help prevent overvaluation and financial bubbles. Short sellers may research securities and publish their findings in an attempt to influence stock price. As long as this is done ethically with factual information, this may benefit the market by acting as a counterweight to the many individuals promoting a stock because they own it. Historically, short sellers have been instrumental in identifying risks to a security and in challenging questionable statements made by the management of a firm.
NotesShort selling tends to be viewed negatively, particularly after a market crash whereby short sellers may be blamed for rapid price declines. For this reason, short selling is sometimes banned or restricted in a jurisdiction. It should be noted that short sellers may stabilize markets in the long term by helping to counteract irrational exuberance with incentives for healthy pessimism.In practice, shares are borrowed from a broker as opposed to directly from an investor.
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