Short selling

Short selling is an investment or trading strategy.

Lets say that you are speculating on the decline in a stock or other security’s price.

So you borrow shares of that stock (or other asset).

Why borrow? Shares must be borrowed because you cannot sell shares that do not exist.

Then, you sell these borrowed shares to buyers on the open market that are willing to pay the market price. Before the borrowed shares must be returned, you are betting that the price will continue to decline and that you can purchase the shares at a lower cost (later).

If you think that a company’s stock price will go down, you can borrow borrow a number of shares from a lender for a set period and agree to return it with an interest payment later.

If you are wrong, then you will have to buy the shares back at a higher price, at a loss.

Short interest is the percentage of a company’s shares that are loaned out to short sellers but haven’t yet been returned.

If a company has high short interest, that means there are so many shares loaned out to short sellers that it’s hard to find shares on the open market to buy and return to the original owners.

In these situations, one of two things can happen.

If there is no interest in buying the stock, the price will continue to go down, and the short sellers will clean up.
However, if there is a sudden demand for shares, the limited supply of shares that are not already loaned out to short sellers can cause the price to quickly skyrocket. Those stocks, if they get the right news, can go way up, or if they get even worse news, they can go way down. They’ve got great volatility.

Close a short position

You have to buy the shares back on the market — hopefully at a price less than at which you borrowed the asset — and return them to the lender or broker from which you borrowed (in addition to paying the interest/fees/commissions). Until you pay that broker back, you have to keep paying interest to him/her. The interest is paid from your “margin account”.

Example of Short Selling for a Profit

Imagine a trader who believes that XYZ stock—currently trading at $50—will decline in price in the next three months. They borrow 100 shares and sell them to another investor. The trader is now “short” 100 shares since they sold something that they did not own but had borrowed. The short sale was only made possible by borrowing the shares, which may not always be available if the stock is already heavily shorted by other traders.

A week later, the company whose shares were shorted reports dismal financial results for the quarter, and the stock falls to $40. The trader decides to close the short position and buys 100 shares for $40 on the open market to replace the borrowed shares. The trader’s profit on the short sale, excluding commissions and interest on the margin account, is $1,000 ($50 - $40 = $10 × 100 shares = $1,000).

Example of Short Selling for a Loss

Using the scenario above, let’s now suppose the trader did not close out the short position at $40 but decided to leave it open to capitalize on a further price decline. However, a competitor swoops in to acquire the company with a takeover offer of $65 per share, and the stock soars.

If the trader decides to close the short position at $65, the loss on the short sale would be $1,500 ($50 - $65 = negative $15 × 100 shares = $1,500 loss). Here, the trader had to buy back the shares at a significantly higher price to cover their position.

Risk

Selling short can be costly if the seller guesses wrong about the price movement. A trader who has bought stock can only lose 100% of their outlay if the stock moves to zero.

However, a trader who has shorted stock can lose much more than 100% of their original investment. The risk comes because there is no ceiling for a stock’s price—it can rise “to infinity and beyond,” to coin a phrase from comic character Buzz Lightyear. Also, while the stocks were held, the trader had to fund the margin account. Even if all goes well, traders have to figure in the cost of the margin interest when calculating their profits.

The risk of loss on a short sale is theoretically unlimited since the price of any asset can climb to infinity.

Naked short selling

Short selling is legal, unlike “naked short selling,” which is against the law.

Naked short selling is when you sell shares that you can’t confirm actually exist — essentially selling a promise that you will get the shares from someone. This used to be fairly common. The SEC banned the practice in 2008 as a result of the financial crisis and run on financial-related stocks that some say sharpened the market turmoil. The problem is that naked short selling can cause the short bet against a company to be larger than the shares available in the market. It facilitates manipulation in stock prices since the short bet is not connected to the amount of shares available.

Take aways

Short selling occurs when an investor borrows a security and sells it on the open market, planning to buy it back later for less money.
Short sellers bet on, and profit from, a drop in a security’s price. This can be contrasted with long investors who want the price to go up.
Short selling has a high risk/reward ratio: It can offer big profits, but losses can mount quickly and infinitely due to margin calls.

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Margin account

The Financial Industry Regulatory Authority (FINRA), which enforces the rules and regulations governing registered brokers and broker-dealer firms in the United States, the New York Stock Exchange (NYSE), and the Federal Reserve have set minimum values for the amount that the margin account must maintain—known as the maintenance margin.1 Financial Industry Regulatory Authority. “Margin Regulation.”

If an investor’s account value falls below the maintenance margin, more funds are required, or the position might be sold by the broker.

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