Introduction to Short Selling
Public companies can have hundreds of millions of outstanding stocks, owned by various stakeholders which include individual investors, banks, employees, executives, banks and mutual funds. Naturally, all stakeholders believe in the long-term success of the company, which should lead to a rising price of its stocks and to dividend payouts.
On the other hand, “short selling” or “shorting” stocks can lead to profitable trading opportunities in falling stock prices. Investors need to be aware that there are imminent risks associated with shorting stocks, as they can lose more than their initial investment. If an investor bets that a stock’s price will fall and goes short, there is a risk of unlimited losses in case the price skyrockets. When buying a stock, the maximum loss is your initial investment if the company goes bankrupt.
While famous investors do short stocks, the average investor might not have the required capital to withstand the losses or to diversify his portfolio in order to reduce risks when a short-position goes against him. Many institutional investors, such as mutual funds, are actually prohibited to short stocks by regulatory authorities in order to protect their investors’ capital.
However, bear markets can reveal lucrative shorting opportunities, so let’s see what does it mean to short a stock and how the average investor can profit from this trading technique.
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 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 where the investor puts up a part 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 tumbles, shorting stocks can indeed generate significant profits if the investor makes the analysis right. However, if the investor’s analysis is wrong and the price of the shorted stock starts to rise, the investor is at risk of losing more than the initial investment.
- Short sellers are often considered as a dangerous force that bets against the success of a company and its stakeholders. But in reality, they provide liquidity to the market by selling the borrowed stocks to investors who are willing to buy it. This way, short sellers prevent that the price of a stock rises to extremely high levels on over-optimism by providing a constant selling power to 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
Short selling can also be used in market-neutral trading strategies, where the investor is focused on preserving his capital and not necessarily on generating large returns. For example, if an investor is long on stock XX in the amount of $100,000, he may want to hedge that trade with a short position on a positively correlated stock, YY. Since there are no perfectly correlated stocks, the investor 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 brighter outlook in terms of revenue, profits and market positioning. Once his analysis is done, the investor could go long in the stocks of Ford, and simultaneously go short in the stock of GM. By doing so, he is still exposed to the positive outlook of the car industry, but reduces his risks in case the industry faces unexpected problems (the losses on the long position would be covered by the profits on the short position.)
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 reveal the current market positioning and investor sentiment on the analyzed stock. Extremely high levels of short interest and short interest ratios can signal a so-called short squeeze, where most market participants who wanted to be short are possibly already short. As a result, there is not much selling power left 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 overbought and oversold 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, on the other hand, 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 their underlying security.
To short a stock with options, an investor needs to buy a put option and simultaneously sell a call option with the same expiration date and at the same strike price. By doing so, the put option will increase in value in case that the price of the stock falls. On the contrary, the put option will fall in value and the sold call option will rise in value if the price of the stock rises, generating an overall loss similar to shorting a stock.
However, simulating a short position using options carries certain limitations since options have expiration dates. Once an option expires, the investor has to either to 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 a pharmaceutical company 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 is facing are 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.
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 market 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 skyrocketing in value which reduces the risks for short-sellers.
Short selling stocks can boost the overall performance of the portfolio, but short sellers should 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.
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.