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Short Selling Stocks, a Trading Guide

Historically, buying a stock or “going long” was the primary way of trading or investing in stocks. An investor would simply buy a stock if he believes its price will go up and collect dividend payouts along the way. Fortunately, there is also a way to profit from falling stock prices by “shorting” the stock. In this article, we’ll look at “What is short selling?” and what it means to short a stock, after which you should be able to understand the associated risks and diversify your portfolio with short positions.

  • Short selling involves selling stocks that you don’t own
  • It’s important to understand the risks of shorting stocks
  • Short selling can be used to hedge your long positions
  • Shot selling with options is an alternative to traditional shorting
Stocks Highlights

Introduction to Short Selling

Public listed companies can have millions of stocks and shares, which are owned by various stakeholders, including mutual funds, hedge funds, pension companies, investment banks, company executives and employees, plus individual investors. By definition, all shareholders believe in the medium to longer term prospects of the company, for a rising price of its shares and to healthy distribution of dividends.

Short Selling Stocks

“Short selling” or “shorting” of stocks and shares can also lead to profitable trading opportunities when the share price is falling. Investors and traders should be aware that there are risks associated with shorting stocks, as it is possible that the investor or trader can lose more than their initial investment. If an investor takes the view that the price of a stock is going to go down, and goes “short”, there is a threat of unlimited losses if the stock price goes significantly higher. If you purchase a stock, which is to go “long”, the maximum loss is your initial investment, if the stock price goes to zero if the company goes bankrupt.

Although prominent investors and traders do short stocks, the average individual investor may not have the necessary capital to endure the losses. Many institutional investors, such as mutual funds and pension companies, are actually prohibited to short stocks by regulatory authorities. This is in order to protect their investors’ capital.

However, bear markets can produce profitable opportunities to go short. Here we will now look at what it means to short a stock and how the regular investor can profit from this trading practice.

What is Short Selling?

  • Short selling or shorting refers to borrowing a financial instrument from the broker and immediately selling it at the current market price in the hope that the price will fall in the future.
  • At a later point, the short seller will cover his short position by buying back the stock at the lower price, returning the borrowed stocks to the broker and profiting from the difference in the price.
  • While long positions can be conducted both from cash and margin accounts, short selling is mostly based on margin accounts. This is where the investor puts up a portion of the value of the short position depending on the leverage used. Trading on margin can magnify both the profits and losses.
  • During periods when the stock market goes significantly lower, shorting stocks can indeed generate substantial profits. However, if the investor’s view is wrong and the price of the stock that has been shorted rises, the investor is at risk of losing more than the initial investment.
  • Short sellers are often seen as a negative force, as they “bet” against the success of a company and its stakeholders. In reality, however, they provide liquidity to markets by selling borrowed stocks to investors who are willing to buy them. This way, short sellers can help to prevent a stock rising to extremely high levels on over-optimism, as they provide a constant selling presence in the market.

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Short Selling as a Hedge of Long Positions

Another reason to short a stock can be to hedge a long position. In this case, the short seller isn’t looking to make a profit on shorting the stock, but to cover any potential losses on his long position. Short selling is therefore an important technique in portfolio management and risk diversification.

For example, if an investor holds a long position on stock XX worth $100,000, he may want to hedge that trade by shorting stock XX in the amount of $100,000. This way, any profit on the long position will be annulled by an equal loss on the short position. Similarly, any loss on the long position will be covered by an equal profit on the short position. While this example obviously doesn’t generate profits, there are certain situations where hedges are appropriate. A short-term investor who holds his trades during a month may want to hedge his long position over the weekends by shorting the same stock on Friday and closing the short position on Monday when the market opens. By doing so, the investor is hedged against any events over the weekend which may have an unfavorable impact on his long position.

Short-Selling in Market-Neutral Strategies

Another reason to short a stock might be to “hedge” a long position. In this case, the short seller is not looking to make a profit on shorting the stock, but to cover any potential losses on his long position. Short selling is therefore an important technique in portfolio management and risk diversification.

For example, if an investor holds a long position on stock ABC worth $100,000, he may want to hedge that investment by shorting stock ABC in the amount of $100,000. This way, any profit on the long position will be annulled by an equal loss on the short position. Similarly, any loss on the long position will be covered by an equal profit on the short position. While this example obviously does not produce profits, there are situations where hedges are appropriate. A short-term investor who holds his trades during a month may want to hedge his long position over the weekends by shorting the same stock on Friday and closing the short position on Monday when the market opens. By doing so, the investor is hedged against any events over the weekend which could have a negative impact on his long position.

Short-Selling in Market-Neutral Strategies (Pairs or Relative Value Investing/ Trading)

Short selling can also be used for market-neutral trading strategies, where the investor or trader is focused on preserving capital and not necessarily on generating large returns. For example, if an investor is long on stock ABC in the amount of $100,000, he may want to hedge that trade with a short position on a positively correlated stock, XYZ. Since there are no perfectly correlated stocks, however, the investor or trader is still able to make a profit or loss on the two trades.

Let’s say an investor is optimistic about the US car industry but wants to employ a market-neutral strategy to reduce his risks. He may pick two stocks, like Ford and GM, and come to the conclusion that the former has a better outlook in terms of revenue, profits and market positioning. Once his analysis is done, the investor could go long Ford, and simultaneously go short GM. By doing so, the investor is still exposed to the positive outlook of the car industry but reduces risks in case the industry faces unexpected problems (the losses on the long position would be covered by the profits on the short position.) This strategy is also known as Pairs or Relative Value Investing/ Trading.

Metrics for Short Selling Stocks

There are certain metrics that can be helpful when determining potential candidates to short. Those are the Short Interest and the Short Interest Ratio (SIR). To calculate the Short Interest of a stock, investors need to divide the total number of stocks sold short with the company’s total number of outstanding stocks and multiply the result with 100. The resulting percentage is the stock’s Short Interest.

The Short Interest Ratio (SIR) is calculated by dividing the total number of stocks sold short with the average daily trading volume of the stock.

These two metrics for short selling highlight the current market positioning and investor sentiment on the stock. Extremely high levels of Short Interest and SIR can signal a so-called short squeeze. This is where most market participants who want to be short are possibly already short. As a result, there is less selling power and the price of the stock may rise.

It’s important to compare the current Short Interest and SIR to historic levels and identify potential over extended levels of a stock. There is a significant risk in shorting a stock which is extremely oversold compared to historic levels, and investors are generally advised to avoid shorting in these cases.

Shorting Stocks with Options

Investors can also simulate shorting a stock by using Put and Call options to create a synthetic short position. A Put option gives its holder the right, but not the obligation, to sell the underlying security at the specified price within the specified period of time. A Call option gives its holder the right, but not the obligation, to buy the underlying security at the specified price within the specified period of time. Naturally, the prices of option contracts are directly impacted by the price of the underlying security.

If shorting a stock with options, an investor would usually buy a Put option or. By doing so, the Put option will increase in value if the price of the stock falls..

However, simulating a short position using options carries certain limitations since options have expiration dates. Once an option expires, the investor has to either meet the obligations of the options contract or close out his position. Those time limits don’t exist when shorting a stock the traditional way.

Risks of Short Selling

As already mentioned, shorting a stock involves significant risks if the price of the stock starts to rise. Unlike in the case of a long position, where the total loss is limited to the initial investment (a stock can only fall to $0), there is theoretically an unlimited upward potential for a stock’s price. Since short selling involves borrowing stocks and selling them at the current market price with the expectation that we’ll be able to buy the stocks later at a lower price and return them to the lender, we face the risk that the price of the stock will actually rise.

Let’s explain this situation with an example. If our analysis shows that the stock of company ABC could fall in value in the coming days, we could borrow that stock, sell it at the current price and hope that our analysis proves to be right. However, imagine what would happen if a merger or acquisition is announced the following day. The price of the stock could easily rise multiple times, and we would still need to return the borrowed stocks to the lender. Our loss would be much higher than our initial investment, which is not possible with long positions.

The second risk a short seller faces are from dividend payouts. While this is more an opportunity cost, the short-seller needs to be aware that he is missing on the dividends which he could otherwise collect on a long position.

Risks of Short Selling

There is a Difference Shorting Stocks and Other Asset Classes

Different asset classes carry different degrees of risks when sold short. The risks described above are specific to the stock market, which has different market dynamics compared to the foreign exchange or commodities markets for example. Stocks can be very volatile and influenced by various market news and rumors about CEO resignations or mergers and acquisitions. In case of a bankruptcy, a company’s stock will likely fall to $0, which is hardly the case with currencies and commodities.

Currencies are always quoted in pairs, where shorting a currency involves buying the other currency in the pair. Basically, a short seller is betting that a currency will fall relative to the second currency in the currency pair. Since there’s minimal risk that a currency will lose its entire

value (except if the country defaults), the shorted currency is prevented from rising steeply in value, which reduces the risks for short-sellers.

Short selling stocks can boost the overall performance of a portfolio, but short sellers could also look for opportunities to short sell other asset classes. This can help in reducing risks by diversifying the portfolio across variously correlated asset classes, which have different market dynamics than the stock market.

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Conclusion:

How to Short Stocks

Short selling involves selling a stock or other financial instrument with the expectation that its price will fall. In order to sell short profitably, an investor needs to borrow stocks from his broker, sell them at the current market price and wait for their price to fall. Once the price has fallen, the short seller will buy the stocks at the lower price and return the borrowed stocks to the lender (broker), making a profit on the difference between the selling price and the buying price.

Short selling carries significant risks since the investor is theoretically unlimited losses in case the price of the stock skyrockets. This can lead to losses that exceed the initial investment, which could not be possible with long positions.

Shorting is also a popular way to hedge a long position. An investor may look to hedge his long position over weekends when certain market events could unfavorably impact his long position. This way, any loss generated on the long position would be covered by gains on the short position. Additionally, short selling can be used to construct market neutral portfolios and reduce downside risks.

Considering all mentioned risks of short selling, an investor should only go short on a stock after performing a detailed due diligence of the company’s financial performance. If done right, shorting stocks can boost the total return not only during bear markets.

Stocks Highlights