Shorting a stock simply means short selling shares. Imagine this scenario:
I am an investor and have been studying Tesla stock performance for some time and at the close of business on Jan 29, 2021, the value of Tesla shares closed at 793.53USD.
I assume, based on my analysis and some market information, that the share price of Tesla stock is too high and will drop in the nearest future so I use my margin account with my Broker to borrow 1,000,000 shares of Tesla stock and sold these shares at $793.53 each.
Technically, my margin account with my broker would rise by USD793,530,000(793.53 x 1,000,000) with an obligation to purchase and return the 1,000,000 shares of Tesla stock in the future.
Now my margin account utilization attracts some charges due to my broker however, I have to wait and see what eventually happens with the stock price and I may be requested to replace the loaned shares with short notice, requiring me to cover my short sale immediately – the loaned shares can be recalled at any time.
If my analysis is correct and Tesla’s share price crashes, in the nearest future, by 22% to USD618.95. I would be able to go into the stock market yet again to buy the 1,000,000 shares of Tesla stock back to repay my broker. Please note that I would have made USD174.58 per share of Tesla stock before fees and commission charged on the borrowed shares by my broker.
Moreover, if my analysis is wrong and the Tesla share price keeps rising and there is a call to replace the shares, I have to buy the shares at USD850.17 to meet my obligation towards the agreement with my broker. I would be in a loss of USD56.64 per Tesla share, this translates to USD56,640,000(56.64 x 1,000,000).
Despite the loss, I would still have to pay commission to my broker and dividends to the buyer of the Tesla shares, depending on timing.
Reasons to Short a Stock
Short selling shares is a trading technique popular with speculators, arbitrageurs, hedge fund managers, and individual investors willing to take on a substantial risk of capital loss. The main reasons investors engage in this technique are speculative and Hedging motives:
When an investor researches a stock and concludes that its share price is overvalued and believes that the price will fall. The investor sees an opportunity to make a profit by selling high on the stock and buying it low when the price drops.
This is a practice that protects investors’ stock against risk. When an investor is expecting a downturn in the market and the investor has a portfolio of long stock positions, the investor can short sell a correlated stock in the same sector that he or she expects to fall. If the market falls, the short gains would offset the losses in the long position.
Main Objectives of Short Selling
- Market Downturn Profiteering
Short selling allows the investor to push for positive returns when the prices of major stocks are crashing. A typical example is the Covid-19 pandemic effect on stock markets across nations, the stock prices were on a downturn hence an opportunity for short-sellers.
- Hedge “Long” Positions
An investor can short stocks to hedge stocks they already own. For instance, they can short a sector Exchange-Traded Funds (ETFs) to help hedge several related sector stocks that they may be holding in their portfolio.
- Playing both sides of the market
An investor can consider going long on stocks that are expected to outperform while going short on stocks that are expected to underperform. The investor could also consider buying (going long) and selling (going short) two highly correlated stocks that have moved far apart and that he or she expects to converge.
- Diversifying a portfolio
When a portfolio is completely made up of long positions or the portfolio is dominated by a large position in one stock, a margin account could allow the investor to diversify the portfolio without having to sell his or her current shares of stock.
Risks Associated with Short Selling Shares
When an investor shorts a stock, the investor is exposed to a huge financial risk. Stock prices can be volatile. If no one is selling the stock, or there are many buyers caused by other short sellers attempting to close out their positions as they lose money, the investor may be in a position to incur serious losses. Some of the associated risks are stated below:
- Unlimited loss – there is no limit to how high a stock price can rise hence the risk of loss in short selling is unlimited.
- Dividends and other payments – The investor will be responsible for any dividends, stock splits, or spin-offs paid on the borrowed stock.
- Unfavorable liquidation – the investor may be required by the broker to close the short positions at unfavorable prices, particularly when a stock experiences a sharp surge in price.
- Historical upward trend – the stock market has risen over time based on history. Despite that past performance of stocks is no guarantee of future results, the tendency of the market to rise over time is a potential risk for any short seller.
Shorting a stock is different from regular stock investing: there is a rule designed to restrict short selling from further driving down the price of a stock that has dropped more than 10% in one day compared to the previous day’s closing price. This compounds the risk of losses on a short sale because the stock price could continue to rise with no limit.
Steps to Short A Stock
- Engage a Broker
Anyone planning to short a stock must engage the service of a broker. The broker may be an independent discount broker, like Questrade, or Big Bank Stock Trading Platforms, like, CIBC Investor’s Edge. They manage a pool of stocks owned by investors hence they can borrow shares of another investor to an investor willing to short a stock.
- Open a Margin Account
Some investors and traders use margin in several ways however, anyone interested in short selling should get a margin account that would allow the investor to borrow shares or borrow money to increase his or her buying power. In this case, investors can sell the short marginal stock with up to twice the buying power of a traditional cash account.
The securities such investors hold in his account with the broker act as collateral for the loan, and they would pay interest on the money borrowed. However, to get a margin trading account, the investor needs to apply.
When investors use margin, they must maintain at least 30% of the total value of their position as equity at all times. If market fluctuations reduce the value of the equity in their account, the broker may issue a margin call, which they must meet by adding funds to their account. If they fail to meet a margin call, the broker could buy back the investor’s short position.
- Research Selected Stocks
There is a need for investors to have adequate information about the stock he intends to short and know if other investors short the stock. Research on selected stocks also helps to determine the Short Interest Ratio (SIR) and Days to Cover Ratio (DCR).
The short interest ratio (SIR), otherwise called the short float, compares the number of stock shares currently shorted and the number of stocks available on the market. If the SIR is high, there are a lot of shorted stocks compared to the available stocks. This indicates that the stock is likely considered overvalued by other investors.
The Days to Cover Ratio (DCR), often called short interest to volume ratio, compares the average daily trading volume of stock to the outstanding shorted shares. It tries to show how many days it would take to cover all the outstanding shorted shares at the average trading volume. A high day to cover ratio generally indicates a general market opinion that the stock may fall.
Costs Associated with Short Selling
- Standard Borrowing Cost
There is a standard cost of borrowing shares, an investor can get the information on the standard cost by requesting his or her broker to provide the information.
- Extra Fees on Hard to Acquire Stocks
When the stock is considered hard to acquire due to availability, high-interest rates, or other reasons, extra fees may be charged in addition to the standard borrowing costs. The rates for the extra fees fluctuate and can range from a fraction of a percent of the value of the stock to over 100% of the stock value (on an annual basis). That percentage is prorated by the number of days the short position is open.
- Margin Costs
When short selling is done on margin, — with borrowed cash — margin interest and fees will also apply.
- Dividend reimbursement
If a dividend or stock split is declared while the short position is open, the short seller may have to reimburse the lender for the value of that dividend or stock split.
Short selling is an advanced trading strategy that allows investors to trade on borrowed shares at a cost, it has associated risks despite the potential to generate a high-profit margin. You could lose a lot of money if you’re not experienced.