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Short Selling

Short Selling
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Short selling is a strategic approach in investment and trading that revolves around speculating on a decline in a stock’s or other security’s price. This tactic is considered advanced and is typically recommended for seasoned traders and investors.

Traders often employ short selling as a form of speculation, while investors or portfolio managers may utilize it as a hedge against potential losses in a long position involving the same security or a related one. Speculation entails significant risks and requires a high level of trading expertise, while hedging is a more conventional method aimed at mitigating risk exposure by establishing offsetting positions.

When short selling, an investor initiates a position by borrowing shares of a stock, bond, or another asset that they anticipate will decrease in value. These borrowed shares are then sold to buyers at the prevailing market price. The investor’s strategy relies on the belief that the price will continue to decline before the borrowed shares must be returned. The inherent risk in short selling lies in the fact that potential losses are theoretically unlimited, as the price of any asset can theoretically rise infinitely.

Understanding Short Selling

Short selling involves a seller initiating a short position by borrowing shares, typically from a broker-dealer, with the anticipation of repurchasing them at a lower price to yield a profit. Upon closing the short position, the trader buys back the shares, ideally at a price lower than the initial borrowing cost, and returns them to the lender or broker. Throughout the process, traders must factor in any interest charges or commissions imposed by the broker.

To initiate a short position, traders must possess a margin account and are generally subject to paying interest on the borrowed shares’ value while the position remains open. Regulatory bodies like the Financial Industry Regulatory Authority (FINRA), the New York Stock Exchange (NYSE), and the Federal Reserve have established minimum requirements for maintaining the margin account, known as the maintenance margin.
If the account’s value falls below this threshold, additional funds must be provided, or the broker may opt to liquidate the position.

The logistics of locating available shares for borrowing and returning them post-trade are managed by the broker behind the scenes. While the opening and closing of short positions can be executed through standard trading platforms offered by most brokers, margin trading eligibility is contingent upon meeting specific criteria outlined by each broker.

Why Sell Short?

Short selling is a practice commonly driven by speculation and hedging. Speculators engage in short selling to wager on the decline of a security’s price. If their prediction proves incorrect, they must repurchase the shares at a higher price, resulting in a loss. Short selling entails additional risks, particularly due to the use of margin, and is typically conducted over a shorter time frame, making it more suited for speculative purposes.

Another reason for short selling is to hedge a long position. For example, if an individual holds call options (long positions), they may opt to sell short against that position to secure profits. Similarly, to mitigate potential losses without exiting a long stock position entirely, individuals may choose to sell short in a stock closely linked or highly correlated to the original holding.

Example of short selling for a profit

Consider a scenario where a trader holds a belief that XYZ stock, currently priced at $50, is poised to decline in value over the next three months. To act on this belief, they opt to borrow 100 shares and promptly sell them to another investor. This action renders the trader “short” 100 shares, as they’ve sold stock they didn’t own but instead borrowed. However, it’s crucial to note that executing this short sale hinges on the availability of borrowed shares, which might not always be abundant, especially if the stock is heavily shorted by other traders.

Fast forward a week, and the company whose shares were shorted announces disappointing financial results for the quarter, causing the stock price to plummet to $40. Sensing an opportunity, the trader decides to close their short position by purchasing 100 shares at $40 each from the open market to replace the borrowed shares. The profit realized by the trader from the short sale, excluding fees and interest on the margin account, amounts to $1,000. This calculation derives from the price difference: $50 – $40 = $10, and when multiplied by the 100 shares sold short, yields a profit of $1,000.

Example of short selling for a loss

Now, let’s consider a variation of the previous scenario: suppose the trader opted not to close the short position at $40 but instead chose to keep it open, anticipating a further price decline. However, a competitor emerges and makes a takeover offer for the company at $65 per share, causing the stock to surge.

If the trader decides to close the short position at $65, the loss incurred on the short sale would amount to $1,500, as calculated below: $50 – $65 = a negative $15, and a negative $15 × 100 shares = a $1,500 loss. In this instance, the trader had to repurchase the shares at a significantly elevated price to cover their position.

Pros and Cons of Short Selling

Short selling can prove to be quite expensive if the seller misjudges the price movement. When a trader purchases stock, the maximum loss they can incur is limited to 100% of their initial investment, should the stock plummet to zero.

Conversely, for a trader engaged in short selling, the potential losses can exceed 100% of their original investment. This heightened risk stems from the absence of an upper limit on a stock’s price. Moreover, throughout the short position, the trader must maintain funds in the margin account. Even in the event of a successful trade, traders need to factor in the cost of margin interest when evaluating their profits.

Advantages:

  1. Potential for High Profits: Day trading offers the enticing prospect of significant financial gains for traders.
  2. Low Initial Capital Requirement: Compared to other investment avenues, day trading demands relatively modest starting capital.
  3. Leverage Opportunities: Day trading allows investors to leverage their investments, potentially amplifying returns.
  4. Hedge Against Other Assets: It serves as a strategic hedge against losses in other investment holdings, offering diversification benefits.

Disadvantages:

  1. Risk of Unlimited Losses: Day trading entails the inherent risk of unlimited losses, particularly in volatile markets.
  2. Need for Margin Accounts: Engaging in day trading necessitates the use of margin accounts, which come with their own set of risks and requirements.
  3. Incurrence of Margin Interest: Traders may face margin interest charges, which can erode profits over time.
  4. Vulnerability to Short Squeezes: Day traders are susceptible to short squeezes, where a sudden surge in the price of a stock forces short sellers to cover their positions at a loss.

Closing a position in short selling can pose challenges, especially if there’s a scarcity of shares available for purchase, which often occurs when many traders have shorted the stock or the stock has low trading volume. Conversely, short sellers may find themselves trapped in a short squeeze scenario if the market, or a specific stock, suddenly surges in value.

Nevertheless, high-risk strategies often come with the potential for high rewards, and short selling is no exception. Correctly predicting price movements can lead to substantial returns on investment, especially when utilizing margin to enter the trade. Margin trading offers leverage, allowing traders to commit less of their capital upfront. When executed prudently, short selling can serve as a cost-effective hedge, balancing out other holdings within a portfolio.

For novice investors, short selling is best avoided until they gain more trading experience. However, short selling through exchange-traded funds (ETFs) represents a safer approach due to the reduced risk of encountering a short squeeze.

Additional Considerations with Short Selling

In addition to the potential loss of money resulting from a bond or stock price increase, short selling carries supplementary risks that investors need to take into account.

Shorting uses borrowed money

Shorting also referred to as margin trading, involves opening a margin account where you can borrow funds from the brokerage firm, using your investment as security. Similar to going long on margin, shorting carries the risk of losses escalating quickly, as you’re required to maintain a minimum maintenance margin of 25%. Falling below this threshold triggers a margin call, necessitating additional cash infusion or the liquidation of your position.

Wrong timing

While a company may be overvalued, its stock price might not immediately decline. However, during this period, you remain exposed to factors such as interest, margin calls, and the risk of being called away.

Short squeeze

When a stock is heavily shorted, marked by a high short float and days-to-cover ratio (explained further below), it faces the potential of undergoing a short squeeze. A short squeeze occurs as a stock’s price starts climbing, prompting short sellers to offset their positions by repurchasing the shares they sold short. This buying activity can trigger a self-reinforcing cycle: Increased demand for the shares draws in more buyers, propelling the stock price upwards, and prompting additional short sellers to repurchase or cover their positions.

Regulatory risks

At times, regulatory bodies may enforce restrictions on short selling within a particular industry or across the entire market. This measure aims to prevent panic and undue selling pressure. Consequently, such interventions can lead to abrupt increases in stock prices, compelling short sellers to close their positions at significant financial losses.

Going against the trend

Historical data consistently demonstrates that stocks tend to exhibit an upward trend. Over extended periods, the majority of stocks experience price appreciation. Additionally, even if a company’s performance shows minimal improvement over time, factors such as inflation, or the general increase in prices within the economy, typically contribute to a rise in its stock price to some degree. Consequently, shorting involves wagering against the broader trajectory of the market.

Costs of Short Selling

Short selling incurs additional costs beyond standard trading commissions paid to brokers. These expenses entail:

Margin interest 

Margin interest represents a notable cost when engaging in stock trading on margin. Given that short sales are exclusively conducted through margin accounts, the interest accrued on short trades can accumulate significantly, particularly if short positions are maintained for a prolonged duration.

Stock-borrowing costs

Shares that are challenging to borrow, whether due to high short interest, limited float, or other factors, incur “hard-to-borrow” fees, which can be significant. These fees are calculated based on an annualized rate, ranging from a fraction of a percent to over 100% of the short trade’s value, and are prorated for the duration of the trade.

Because hard-to-borrow rates can vary widely on a daily or even intraday basis, the precise fee amount may not be predictable upfront. Typically, broker-dealers assess the fee to the client’s account either at month-end or upon closing the short trade. When these fees are substantial, they can significantly impact the profitability of a short trade or worsen losses.

Dividends and other payments

The short seller bears the responsibility of covering dividend payments on the borrowed stock and paying the lender the coupon or interest owed for shorted bonds. Additionally, they are obligated to make payments for other occurrences related to the shorted stock, such as share splits, spinoffs, and bonus share issues, which can be unpredictable.

Short Selling Metrics

There are two key metrics utilized for monitoring short-selling activity on a stock:

  1. Short Interest Ratio (SIR), often referred to as the short float, denotes the proportion of shares currently being shorted in relation to the total number of shares available or “floating” in the market. A notably high SIR typically correlates with stocks experiencing a decline or those perceived as overvalued.
  2. The Short Interest-to-Volume Ratio, also recognized as the days-to-cover ratio, is calculated by dividing the total shares held short by the average daily trading volume of the stock. A heightened value for the days-to-cover ratio serves as a bearish signal for a stock’s performance.

Both short-selling metrics provide valuable insights for investors to gauge whether the prevailing sentiment toward a stock is bullish or bearish.

For instance, following the decline in oil prices in 2014, General Electric Co.’s (GE) energy divisions started to weigh down the company’s overall performance. The short-interest ratio surged from less than 1% to over 3.5% by late 2015, indicating that short sellers were anticipating a downturn in the stock. By mid-2016, GE’s stock price peaked at $33 per share before entering a decline. By February 2019, GE had plummeted to $10 per share, potentially yielding a profit of $23 per share for short sellers who had opportunistically shorted the stock near its peak in July 2016.

Ideal Conditions for Short Selling

Timing plays a pivotal role in short-selling endeavors. Typically, stocks plummet at a swifter pace than they ascend. A substantial gain in stock could swiftly dissipate within days or weeks due to an earnings disappointment or other negative developments. Therefore, the short seller must execute the short trade with precision timing. Delaying entry into the trade may result in significant opportunity costs as a substantial portion of the stock’s decline may have already transpired.

Conversely, initiating the trade prematurely could pose challenges in maintaining the short position due to associated costs and potential losses, especially if the stock surges rapidly.

At times, the prospects for successful shorting improve under the following conditions:

  1. During a bear market:
    Shorting tends to thrive in bear markets, where the dominant trend for a stock market or sector is downward. Traders who adhere to the principle of “the trend is your friend” stand a better chance of profiting from short-sale trades during entrenched bear markets, such as the global bear market of 2008–2009, characterized by swift, broad, and deep declines.
  2. When stock or market fundamentals are deteriorating:
    Deteriorating fundamentals, such as slowing revenue or profit growth, increasing business challenges, or rising input costs, can signal potential opportunities for short sellers. In broader markets, weakening fundamentals might include adverse geopolitical developments, signals of economic slowdown, or bearish technical indicators like new highs on decreasing volume. Experienced short sellers often wait for confirmation of a bearish trend rather than anticipating it, as stocks or markets may trend higher despite deteriorating fundamentals, especially in the final stages of a bull market.
  3. Technical indicators confirming the bearish trend:
    Short sales may gain a higher probability of success when multiple technical indicators confirm the bearish trend, such as a breakdown below a key long-term support level or a bearish moving average crossover like the death cross—when a stock’s 50-day moving average falls below its 200-day moving average. Technical indicators help identify new price trends.
  4. Valuations reach elevated levels amid rampant optimism:
    Periodically, valuations for certain sectors or the overall market may become highly elevated due to widespread optimism. This phase, termed “priced for perfection” in the investment cycle, often leads to disappointment when lofty expectations aren’t met. Rather than hastily shorting, experienced short sellers wait for the market or sector to roll over and begin its downward phase.

John Maynard Keynes, a renowned British economist, once remarked, “The market can stay irrational longer than you can stay solvent,” underscoring the challenges of short selling. The optimal time for shorting typically arises when multiple factors mentioned above align.

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