At its core, short selling consists in selling a financial instrument that has been borrowed. It is widely practiced but far less so than traditional investing (going long). This is the result of it being somewhat controversial and misunderstood, the risks involved, the skill set required for it to be consistently profitable and other barriers.
To sell short one must have a margin account and fund it with a certain amount of margin/collateral. Margin required to short shares varies considerably depending on the type of shares. For example, penny stocks are characterised by low prices and high levels of volatility, consequently margin requirements are very large. In USA equity markets, some brokers ask for as much as $2.50 collateral for all shares worth less $2.50, meaning that if 1,000 shares priced at $0.10 are sold short, $2,500 worth of margin/collateral would be needed, despite the value of the shares being a mere $100.
On the other hand, the standard margin requirement for most shares is 150%, meaning that the collateral needed to short a share would need to be 50% of the value of the shares at the time they were sold short. Thus, if one wishes to short 1,000 shares priced at $10, one would need only $5,000 worth of margin/collateral, despite the value of the shares being $10,000.
The steps of short selling
Short selling process involves the following steps:
- You place a short sale order through your broker.
- Your broker will try to borrow (or “locate”) the shares from many different sources, such as its own inventory, from other margin accounts or even from other brokers.
- When the shares have been borrowed, they will be sold and the proceeds will be deposited in your account. In the USA, because of the uptick rule, any short sale can only take place if the price of the stock has increased or dropped by less than 10% in one day.
- You buy the shares and return them to your broker to close the position. If the price of these shares is lower than the price at which you sold them, you pocket the difference and make a profit. If the price is higher, you must make up the difference and incur a loss.
The drawbacks of short selling
Despite it being practiced by many people, short selling is not popular. This largely the result of its numerous potential downsides, such as:
- Expenses/Costs: Short selling is relatively expensive. Borrowing costs plus the interest of a margin account can add up.
- Timing Is crucial: A poorly timed short sale can prove extremely expensive. Consequently, basic fundamental and technical analysis skills are a prerequisite for any aspiring short seller.
- Limited return on investment and unlimited losses: The maximum rate of return of any short sale is 100%, which happens when the price of the shorted shares falls to zero. On the other hand, the price of the shorted shares can in theory increase indefinitely, meaning that in theory a shorting sale gone wrong can result in indefinite losses.
- Barriers to short selling certain types of stocks: Most large brokers will allow you to purchase any stock you please. The same cannot be said about borrowing. Some shares are very illiquid, consequently borrowing them is often times not possible. The only way to go around this is by trading with certain brokers that are able to borrow a large inventory of these illiquid stocks. These brokers are not well known and only offer margin accounts with high collateral requirements, which precludes many traders from getting involved.
- Regulatory risk: Market regulators may temporarily ban short selling because of market conditions, which could result in market rally that causes the short seller to incur losses.
- “Buy in” risk: Short positions on heavily shorted stocks have a higher risk of “buy in”, meaning thar the broker is more likely to close it if for example the lender of the stock asks for it back.
Why you should consider short selling
Besides the above risks, short sellers are often times ill perceived and vilified. Many among you are probably asking “why short sell or learn about it?”. The answer is a simple one. Prices fall faster than they rise. Over the last two decades we have seen two major stock market crashes and countless failed companies and scams. Understanding the nuances of short selling can thus not only allow one to gain a skillset that can be highly profitable, it can also teach one the needed scepticism and research skills to spot the many hazards that can be found in the world of finance.
In the next article in the series will taking a quick look at the history of short selling.