Short selling-- a description
PRO TRADER INTELLIGENCE REPORT-What is short-selling?
"Buy low, sell high," but not necessarily in that order. The easiest point of
reference to understand short-selling (or selling short) is that it is the
opposite of buying. So let us first answer the question, "What is buying?" When
you buy 100 shares of XYZ stock, you are paying the seller of those shares so
that you may own it. You do this because you believe -- for whatever reason --
that those shares' price will rise, allowing you the opportunity to sell at a
higher price. The new buyer would then give you money reflecting that higher
price, and the difference between that and what you initially paid for the
shares would represent your profit.
If short-selling is the opposite, then the first step is to sell 100 shares of
XYZ because you believe that those shares' price will fall. But where did you
get those shares to sell? It is at this early point of the explanation that most
people become confused, and walk away from the potential profits and portfolio
diversification that shorting offers, out of their ignorance mis-labeling the
tactic as "risky". Yet, the answer is really quite simple: You were able to sell
those shares that you did not own because you borrowed them. (Perhaps if we
considered in our definition of buying a stock that you did not have the money
to begin with, so you had to borrow it, the reverse-analogy would be even more
clear.)
Brokerages make a good chunk of their revenues from loaning stock that they hold
for their customers to other customers who want to short it; they even loan it
out to other brokerage firms who have customers that want to short it, but not
enough customers who own it to loan it themselves. If you own shares of a stock
in your brokerage account that you have not specifically requested be held in
"safekeeping", then it is quite possible that those shares presently are not
even in your broker's custody
Now you are "short" the stock anticipating that its share price will fall so
that you may later buy it back at the lower price, delivering the shares back to
the brokerage as if paying off any other loan. The difference between the price
at which you sold those shares short and the price at which you will buy them
back (or covered), less any commissions and fees, will represent your profit
(or loss).
Short-selling is the opposite of "buying low and selling high," just not in that
order.
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Why sell short?
Why buy long? The markets are built upon the capitalist system, and the
capitalist system is built upon a motivation to make a profit. It is often said
that short-selling's intention is to profit from the misfortune of others. But
when you buy a stock and its price rises, didn't the seller have the misfortune
of selling too soon?
You will read more about why we sell a stock short in a future essay about
"Charting and Technical Analysis".
Another important reason to pursue short-selling is for portfolio
diversification. Think about your investments. Is your entire investment
portfolio's value represented by ownership of just one stock? Of course not. If
you are like most investors, then you own different of stocks or mutual funds
that represent different companies and industries. You do this because you know
that those different holdings do not react similarly to the varying economic
changes and forces, or because you do not want to see your net worth plummet
because the one investment decision you made turned out to be wrong, even if
only temporarily.
But all stocks -- from small-cap to big-cap, from Aerospace to Toys -- are each
in the same asset class, simply by virtue of being stocks. Is this truly
diversification? Adding bonds or bond funds to a portfolio is certainly a step
toward further diversification, but don't stocks and bonds tend to react
similarly to interest rate movements? So many risk-averse investors turn to
short-selling as a hedge against their portfolios' volatility. Besides, the
different sectors of the stock market don't just rise at different rates; some
decline as traders sell shares in one pricey industry to buy shares in another
one they perceive to be undervalued (also known as sector rotation).
A portfolio that does not have short positions along with stocks that it owns
outright will tend to fluctuate more widely in value, and will miss an important
tactic in profiting from the stock market's own fluctuations and sector
rotation.
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How to short sell
As described above under "What is short-selling?" selling short is accomplished
simply by placing a call to your broker and asking if you can borrow a certain
number of shares of a certain stock to sell short. Your broker then relays your
question to his or her brokerage's Stock Loan or Margin department, often while
you are briefly on hold during the phone call. Assuming that the stock is
available to loan to you, or that the brokerage could borrow the stock from a
competitor to loan to you, you then place a sell order with your broker as you
would place any sell order.
So what happens to the money that was raised by the sale of the borrowed shares?
Initially, fifty percent of it must remain in the trading account in which you
shorted the stock. This is called margin, and it must reflect no less than 35%
of the shorted stock's value at any given time (with some brokerages that
minimum may be slightly higher). If you take any of the un-required margin
balance or sale proceeds, and the shorted stock's value rises to a level at
which the remaining margin balance falls below that 35% minimum, then you will
be required to deposit more money into the account or to buy the stock back to
cover the short position. (This risk is dealt with more fully in the Risk vs.
Reward section below.) There is also interest charged to your account against
the value of the outstanding short position.
When the stock's price reaches a level that meets your goals, or that exhibits
some sort of trading action from which you reason that the downtrend is over,
you call your broker and place a buy order -- very similar to any other buy
order -- to lock in the lower price, and to off-set your account's short
position, thus closing out the position and your risk exposure. As described
earlier, your profit would be based on the difference between the price at which
you shorted the stock, less the price at which you bought it back to cover the
position, less any commissions and fees.
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Other techniques (used on senior exchanges only)
In many instances, you need not actually borrow the stock to benefit from a
price decline:
The stock could be so heavily shorted by other market players that it is simply
not available to loan.
You anticipate that the price decline will happen quickly, or you want to
leverage your commitment.
You want to limit your risk.
The natural option is exactly that -- options. A single option contract is an
agreement for the delivery of 100 shares of a certain stock within a certain
time frame at a certain price. The buyer of that option may exercise the terms
of the contract when he wishes to, and the seller (or writer) of that option
commits himself to fulfill those terms when asked. There are two types of
options:
Puts. The buyer of this option has the right to sell the underlying shares to
the option writer.
Calls. The buyer of this option has the right to buy the underlying shares from
the option writer.
There are many characteristics and risks to option contracts. In fact, the
booklet titled, Characteristics and Risks of Standardized Options is required
reading before trying to trade them. But if you project a price decline in XYZ
stock of 20% within two months (as an example), often a put option contract with
an exercise price close to XYZ's current price will return several times the
20%. The initial purchase price of an option to control 100 shares of XYZ would
be less than the full price or potential exposure (if shorting) to control those
100 shares, so for the same potential absolute dollar gain, the risk exposure
can be curtailed.
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Risk vs. Reward
We have touched briefly on the concept that not exposing your portfolio to some
short positions carries certain un-hedged, less diversified risks, and that the
reward to adding this tactic is that your account's value will tend to be less
volatile and potentially more profitable. But like any other transaction, there
is always the risk that the price at which you shorted a security proves to be
too low, and the shares rise even higher in value. As described above, a certain
minimum ratio of equity must be maintained relative to the cost of covering the
outstanding short position.This is a Federal Reserve regulation and your broker
may have a "house" minimum that is higher than the mandated minimum.
Therefore, if the shorted stock rises in value, it is possible that a margin
call will be triggered which requires you to bring your account's equity ratio
back up to the minimum requirement. Your choices are either to deposit the extra
cash or to sell enough shares so that the combination of the sale proceeds and
the reduced short position will bring your account's equity ratio back into
compliance.Sometimes, fluctuations in the shorted stock's value will itself
bring your account back into compliance, but this is no assurance that your
broker will not still want the original margin call to be met, if only as a
formality.
So, unlike holding a stock long through a price decline, anticipating a recovery
to higher prices and only suffering the loss on paper, shorting a stock may
require you to act if prices move against you. And how much can they move
against you? Again, grasping this concept is easiest when compared to holding a
stock long. When you buy a stock, the most that you can lose is everything; that
is, no matter what you paid for the shares, the lowest price to which they can
trade is zero, representing a loss of 100%. But when you short a stock, your
reach the 100% loss level when the share price doubles; and if the stock's price
continues even higher and you maintain your short position, meeting margin calls
along the way, your potential loss could exceed 100%.The same principle can be
applied to potential gain, as well: A long stock position may eventually double
or triple or more, but the maximum profit potential for a short stock position
is limited to 100%.
Another risk to shorting stocks is commonly called a short squeeze. In a short
squeeze, a high-volume buying wave drives prices higher. This euphoria sparks
even more buying by new participants wanting to establish a long position and by
existing shareholders who want to increase theirs. It may also "scare" those who
are short the stock into covering their positions. This event may be triggered
by an unforeseen news announcement or simply by an important resistance level
being broken. Another characteristic of a short squeeze is that many of the
buyers demand delivery of their shares, or that they be placed in safekeeping,
and therefore not allowable for lending to short sellers. Since their is a
finite number of outstanding shares issued, your broker may force you to deliver
the originally borrowed shares back to the brokerage house so that they can be
delivered to a buyer. The effect is that you must cover your short position
regardless of your desire to maintain the short. This is why 'stop loss'
orders are important to minimize the effect of a stock moving against you.
You can always short the stock again at a later date!
Options can help to avoid some of the risks described above. When purchasing a
put option instead of shorting a stock, you are long the put option even though
you are intending to profit by a price decline in the underlying shares;
therefore, your potential loss is limited to 100% and your potential gain is
unlimited. But one of the features of an option contract is the date by which
its terms must be exercised by its owner, after which the contract expires; this
introduces the risk that the anticipated price decline in the underlying shares
does not materialize soon enough or to a great enough degree to recover the cost
initially paid to purchase the option. Also, a call option can be purchased as
"insurance" against the short position's risk, but also limiting the potential
profit.
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