Short selling 101

Short selling is an interesting name to describe selling a stock you don’t own on the open market. How is that possible you say? Well first of all, you can only use this technique if you have a margin account. Basically you borrow shares from your broker, then when you sell the shares, the proceeds you earn are credited to your margin account. The broker will loan the shares to you from their own inventory, from one of their customers, or maybe even from another brokerage firm.

You need a margin account because your broker needs to know that even though you would rather borrow than buy these particular shares, that you have the minimum credit requirements in your account to cover the cost of the shares you borrowed.

When would you do a short sell?

It’s really anytime you think a stock will decline and you see an opportunity to make a profit. But remember, you are borrowing someone else’s stocks, and at any time they can ask to have them back, whether it’s your broker or the original owner of the stocks. When the original owner wants their shares back so they can sell them, it’s called a forced buy-in. You would have to return the borrowed shares to the broker by market opening of the following trading day. Regardless of who wants the shares back, you need to be able to the cover the cost.

Are there other costs involved in a short sell?

Aside from ensuring you can cover the cost of the sale in your margin account, there may be a variety of costs for a short sell, such as a borrowing cost, a commission cost, an interest cost on your margin account, and you may even have to pay dividends. The borrowing costs vary depending on the type of shares. For example, a stock that is in high demand or experiencing high volatility may be considered “hard-to-borrow” and would therefore have a higher fee. If dividends were declared during the time you borrowed the shares, you may have to pay dividends to your broker (the lender of the stock).

Why would you do a short sell?

Well, to make money of course, but is the chance of profit high enough on this type of transaction to cover the costs? It can be but not always. There are two main reasons why you would short sell.

  • Speculate: Let’s say you’ve been researching a stock. It’s not one you own. You decide it is overvalued and believe the price will fall. You speculate that you can sell that stock at a high price then make a profit by buying it back at a lower price when the price drops. So you borrow that stock to sell.
  • Hedge: In this scenario, you own stock (referred to as a long position) that you want to protect against risk. Again, you do your research and find a stock that you believe is overvalued or perhaps you think the market is heading for a downturn. To protect your long positions, you would do short sell on that stock. If the stock falls as you predicted, the short gains would offset the losses in your long position.

So what’s the risk of a short sell?

Here are just four risks when considering a short sell:

  • You can lose money. There’s no limit on how high a stock can rise before it drops in price, and that can mean losses for you. For example, you borrow 200 shares of stock from your broker for ABC Company and you short sell the shares at $100 each. You expect the stock price to fall so you can buy the shares back at a lower price but instead, several weeks later, the stock price increases to $120. To cover your short position on your margin account, you have to go to the open market and buy the stock at a price higher than you sold it for. In this case, for $120. At $20 for 200 shares, you’ve actually lost $4,000. And if the stock kept rising in value, your potential loss is unlimited.
  • The price can go up instead of down and you can be in a short squeeze. If we continue with the example earlier of the stock price increasing instead of decreasing, when there are many short sellers also trying to cover their short positions at the same time, it actually causes the stock price to rise even further.
  • There are no stocks available to borrow from your broker, or as they would say, no inventory.
  • The broker may ask you to cover the short sell, and it may not be at a favourable price (meaning you could lose a lot of money).

What’s the possible gain in a short sell?

Using our example when we looked at the risk, let’s say now that instead of increasing in price, that price decreased as you predicted. So you borrowed 200 shares and you short sell them at $100 each. This time the stock falls in value as you predicted, and it is now $50. You buy the stock back at $50 x 200 for a profit of $10,000, less any costs of course.