Short Selling

When Stock or Market Fundamentals are Deteriorating

A stock's fundamentals can deteriorate for any number of reasons—slowing revenue or profit growth, increasing challenges to the business, rising input costs that are putting pressure on margins, and so on. For the broad market, worsening fundamentals could mean a series of weaker data that indicate a possible economic slowdown, adverse geopolitical developments like the threat of war, or bearish technical signals like reaching new highs on decreasing volume, deteriorating market breadth. Experienced short-sellers may prefer to wait until the bearish trend is confirmed before putting on short trades, rather than doing so in anticipation of a downward move. This is because of the risk that a stock or market may trend higher for weeks or months in the face of deteriorating fundamentals, as is typically the case in the final stages of a bull market.

Going Against the Trend

History has shown that, in general, stocks have an upward drift. Over the long run, most stocks appreciate in price. For that matter, even if a company barely improves over the years, inflation or the rate of price increase in the economy should drive its stock price up somewhat. What this means is that shorting is betting against the overall direction of the market.

Short Selling as a Hedge

Apart from speculation, short selling has another useful purpose—hedging—often perceived as the lower-risk and more respectable avatar of shorting. The primary objective of hedging is protection, as opposed to the pure profit motivation of speculation. Hedging is undertaken to protect gains or mitigate losses in a portfolio, but since it comes at a significant cost, the vast majority of retail investors do not consider it during normal times. The costs of hedging are twofold. There's the actual cost of putting on the hedge, such as the expenses associated with short sales, or the premiums paid for protective options contracts. Also, there's the opportunity cost of capping the portfolio's upside if markets continue to move higher. As a simple example, if 50% of a portfolio that has a close correlation with the S&P 500 index (S&P 500) is hedged, and the index moves up 15% over the next 12 months, the portfolio would only record approximately half of that gain or 7.5%.

Wrong Timing

Even though a company is overvalued, it could conceivably take a while for its stock price to decline. In the meantime, you are vulnerable to interest, margin calls, and being called away.

The Short Squeeze

If a stock is actively shorted with a high short float and days to cover ratio, it is also at risk of experiencing a short squeeze. A short squeeze happens when a stock begins to rise, and short-sellers cover their trades by buying their short positions back. This buying can turn into a feedback loop. Demand for the shares attracts more buyers, which pushes the stock higher, causing even more short-sellers to buy back or cover their positions.

Short Selling for a Profit

Imagine a trader who believes that XYZ stock—currently trading at $50—will decline in price in the next three months. They borrow 100 shares and sell them to another investor. The trader is now "short" 100 shares since they sold something that they did not own but had borrowed. The short sale was only made possible by borrowing the shares, which may not always be available if the stock is already heavily shorted by other traders. A week later, the company whose shares were shorted reports dismal financial results for the quarter, and the stock falls to $40. The trader decides to close the short position and buys 100 shares for $40 on the open market to replace the borrowed shares. The trader's profit on the short sale, excluding commissions and interest on the margin account, is $1,000: ($50 - $40 = $10 x 100 shares = $1,000).

Margin Interest

Margin interest can be a significant expense when trading stocks on margin. Since short sales can only be made via margin accounts, the interest payable on short trades can add up over time, especially if short positions are kept open over an extended period.

Valuations Reach Elevated Levels Amid Rampant Optimism

Occasionally, valuations for certain sectors or the market as a whole may reach highly elevated levels amid rampant optimism for the long-term prospects of such sectors or the broad economy. Market professionals call this phase of the investment cycle "priced for perfection," since investors will invariably be disappointed at some point when their lofty expectations are not met. Rather than rushing in on the short side, experienced short-sellers may wait until the market or sector rolls over and commences its downward phase. John Maynard Keynes was an influential British economist whereby his economic theories are still in use today. However, Keynes was quoted saying: "The market can stay irrational longer than you can stay solvent," which is particularly apt for short selling. The optimal time for short selling is when there is a confluence of the above factors.

Pros of Short Selling

Possibility of high profits Little initial capital required Leveraged investments possible Hedge against other holdings

Cons of Short Selling

Potentially unlimited losses Margin account necessary Margin interest incurred Short squeezes

Regulatory Risks

Regulators may sometimes impose bans on short sales in a specific sector, or even in the broad market, to avoid panic and unwarranted selling pressure. Such actions can cause a sudden spike in stock prices, forcing the short seller to cover short positions at huge losses.

Stock Borrowing Costs

Shares that are difficult to borrow—because of high short interest, limited float, or any other reason—have "hard-to-borrow" fees that can be quite substantial. The fee is based on an annualized rate that can range from a small fraction of a percent to more than 100% of the value of the short trade and is pro-rated for the number of days that the short trade is open. As the hard-to-borrow rate can fluctuate substantially from day to day and even on an intra-day basis, the exact dollar amount of the fee may not be known in advance. The fee is usually assessed by the broker-dealer to the client's account either at month-end or upon closing of the short trade, and if it is quite large, can make a big dent in the profitability of a short trade or exacerbate losses on it.

Short Selling Metrics

Short interest ratio (SIR) The short interest to volume ratio

Technical Indicators Confirm the Bearish Trend

Short sales may also have a higher probability of success when the bearish trend is confirmed by multiple technical indicators. These indicators could include a breakdown below a key long-term support level or a bearish moving average crossover like the "death cross." An example of a bearish moving average crossover occurs when a stock's 50-day moving average falls below its 200-day moving average. A moving average is merely the average of a stock's price over a set period of time. If the current price breaks the average, either down or up, it can signal a new trend in price.

What Is Short Selling?

Short selling is an investment or trading strategy that speculates on the decline in a stock or other security's price. It is an advanced strategy that should only be undertaken by experienced traders and investors.

Shorting Uses Borrowed Money

Shorting is known as margin trading. When short selling, you open a margin account, which allows you to borrow money from the brokerage firm using your investment as collateral. Just as when you go long on margin, it's easy for losses to get out of hand because you must meet the minimum maintenance requirement of 25%. If your account slips below this, you'll be subject to a margin call and forced to put in more cash or liquidate your position.

During a Bear Market

The dominant trend for a stock market or sector is down during a bear market. So traders who believe that "the trend is your friend" have a better chance of making profitable short sale trades during an entrenched bear market than they would during a strong bull phase. Short sellers revel in environments where the market decline is swift, broad, and deep—like the global bear market of 2008-09—because they stand to make windfall profits during such times.

Dividends and other Payments

The short seller is responsible for making dividend payments on the shorted stock to the entity from whom the stock has been borrowed. The short seller is also on the hook for making payments on account of other events associated with the shorted stock, such as share splits, spin-offs, and bonus share issues, all of which are unpredictable events.

Ideal Conditions for Short Selling

Timing is crucial when it comes to short selling. Stocks typically decline much faster than they advance, and a sizeable gain in a stock may be wiped out in a matter of days or weeks on an earnings miss or other bearish development. The short seller thus has to time the short trade to near perfection. Entering the trade too late may result in a huge opportunity cost in terms of lost profits, since a major part of the stock's decline may already have occurred. On the other hand, entering the trade too early may make it difficult to hold on to the short position in light of the costs involved and potential losses, which would skyrocket if the stock increases rapidly. There are times when the odds of successful shorting improve, such as the following:

Costs of Short Selling

Unlike buying and holding stocks or investments, short selling involves significant costs, in addition to the usual trading commissions that have to be paid to brokers. Some of the costs include:

Short Selling for Loss

Using the scenario above, let's now suppose the trader did not close out the short position at $40 but decided to leave it open to capitalize on a further price decline. However, a competitor swoops in to acquire the company with a takeover offer of $65 per share, and the stock soars. If the trader decides to close the short position at $65, the loss on the short sale would be $1,500: ($50 - $65 = negative $15 x 100 shares = $1,500 loss). Here, the trader had to buy back the shares at a significantly higher price to cover their position.

The short interest to volume ratio

also known as the days to cover ratio—the total shares held short divided by the average daily trading volume of the stock. A high value for the days to cover ratio is also a bearish indication for a stock.

Short interest ratio (SIR)

also known as the short float—measures the ratio of shares that are currently shorted compared to the number of shares available or "floating" in the market. A very high SIR is associated with stocks that are falling or stocks that appear to be overvalued.