Short Selling

When an investor buys a stock, the hope is often that it will appreciate in value immediately or over time. That is one way to make profit on stock, but there is also another method called short selling. Shorting a stock can be a riskier strategy, but it can also yield relatively high returns when executed successfully. With high returns often comes high risk, so investors should understand the ins and outs before diving in.

What Is Short Selling?

When there are downturns in the market, it can create an opportunity for marketers to short sell. This is when an investor borrows shares or securities and then sells them with the intent of repurchasing the stock at a lower price. The key to success in short selling is being able to predict when a security will fall in value and selling once it does. You then repay the loan and keep whatever profit you have left.

For instance, you may see a stock selling for $30 per share on the market and have an inclination that it’ll eventually fall in price. As a result, you may decide to borrow 100 shares from your brokerage–the equivalent of $3,000–and then sell them. Let’s say the price of the stock falls to $15 per share and you seize the opportunity to repurchase $100 shares at $1500. You could then return the initial 100 shares you borrowed to the brokerage and would have made a profit of $1500 minus any interest you may owe. That said, before short selling, you want to estimate the interest you’ll pay the brokerage in addition to potential commission and fees to ensure the investment is worthwhile. Also remember, nobody can predict the market, so tread carefully.

How Short Selling Works

The first step in short selling is opening and funding a margin account-a type of brokerage account where a broker dealer can use assets an investor places inside as collateral. You usually must have at least 50% of the loan value in your account in the form of cash or securities. Since there are very few loans you’ll get for free, you must also pay interest on the shares you borrow until they’re returned. The amount and frequency of interest charged varies between brokers.

Short selling can drift into illegal terrain when traders do what’s called naked short sales. This is when you sell shares that you haven’t yet borrowed or don’t exist. The trader would end up attempting to sell shares they don’t have with hopes that the prices fall and they make a profit. To prevent this practice, many brokerages have a regulatory requirement called “locate” for a security. This process ensures the security you’re attempting to short sell can be borrowed and delivered on a particular date.

Identifying Opportunities

How do you choose the right security to short sell? There are a few strategies an investor could consider.

Short interest
This percentage or ratio tells an investor how many open short positions a brokerage reports during a set period. Investors can get the formula for short interest by dividing the number of shares sold short by the total number of shares outstanding.

Fundamental analysis
The same way you analyze whether a company has high performance before investing in a stock, you can also do an analysis to identify potential declines in performance. More specifically, you may look for declines in earnings per share or sales growth.

Technical analysis
Investors can take time to identify patterns in a stock’s price and performance to see if they identify any downward trends.

Thematic
If an investor notices a company isn’t evolving, this may pose a short selling opportunity. For instance, if an investor saw MySpace might be left behind due to the emergence of competitors like Facebook and Twitter, they might have made a profit short selling said stock.

Risks of Short Selling

One main risk of short selling is that your stock may not fall in price. In this instance, you could experience limitless losses. What this means is that the stock price can keep rising and there would be no limit to the amount you’d have to spend to replace the shares you borrowed.

Using the same example above, if you borrowed 100 shares for $30 (the equivalent of $3,000) and the stock price climbed progressively to $100 per share, you would have to buy back $10,000 worth of shares. That’s $7,000 more than what you borrowed. If it’s a popular stock that several investors are trying to short sell that suddenly rises in value, you may find multiple investors trying to buy it back at once. This demand could trigger a price increase which could lead to even greater losses.

To control significant losses while short selling, investors could consider stop orders, which is when you determine a set price that a trader would have to buy the stock back at. For instance, using the example above, you could put a stop order at $35 so you know there’s a limit to your losses.

Other risks that come with short selling include rising interest rates on your loan, and margin calls-where your broker asks you to deposit more money or assets into your account because your account falls below the minimum equity requirement.

Considering the risk involved, do enough research or speak to one of our finance professionals before short selling.