Most investors purchase their investments with hopes that the investments will increase in value across time, or for income investments, at least not lose value. Short sellers do the opposite; they are looking to profit from a decline in value.
To profit off a decline, they typically sell an asset they don’t own, planning to replace it later at a lower cost. The decline in value between the time they sell it and the time they purchase it to replace what they sold becomes their gain.
The process can be complex and there are rules involved — you’re not generally allowed to just sell an investment you don’t own. Investors can also use a short-selling strategy as a hedge; it can be used either to make a profit directly or to limit losses elsewhere. In most cases, there is a lot more risk in selling short.
The Basics of Short Selling
The brokerage can loan out assets from most of their margin accounts that have debit balances. There are restrictions that make it more cumbersome for them to loan out of other accounts, so they tend to not do so.
Most of our discussion here will be applicable to shorting stocks or bonds, although shorting can also apply to futures and other contracts.
Institutional investors and custodial banks are also sources of shares to be shorted; they often lend shares to make additional profit.
With derivatives, there is no asset to borrow; the side of the contract that benefits from a decline in value is said to be short.
For an investor to sell short, they need to be able to borrow the security. Their brokerage may either have the security to lend out or may locate the security elsewhere to provide it for the short sale.
The investor pays the brokerage for the use of the security during the time between making the short sale and covering the short sale by repurchasing the security.
The brokerage typically charges a rate, similar to an interest rate, for the use of the security.
Investors in the United States are not generally allowed to make naked short sales. A naked short is when you sell a security without borrowing it or otherwise securing it for you to sell. There are some exceptions for market makers.
Short sellers typically must have margin with their brokerage; the brokerage needs to know the investor can cover the short sale. The brokerage may seek additional cash or force the investor to close the position if there becomes too much risk for the brokerage.
Limited Potential for Gain, Unlimited Potential for Loss
The risk/reward relationship for short sales is the opposite of traditional investing.
A traditional investor who purchases a security can lose, at most, their initial investment, plus any costs or fees. Their potential gain is theoretically unlimited; there is no actual cap on how high the value of an investment can go.
The short seller has the opposite side of this relationship. The most they can possibly make is the value of the security at the time they sell it short, less any costs or fees. This is their limit as the value of a security cannot drop below zero; this limits their potential gains.
The short sellers’ losses are theoretically unlimited.
No matter how high the price of the security sold short goes, they ultimately have to repurchase it and replace what they sold.
Many short sellers limit their risk by using stop orders to automatically sell the stock if it increases to a certain price, limiting their potential for loss.
The costs of short selling and the inverse risk/reward relationship make it a short-term strategy. Being “short” longer-term dramatically increases the costs and risks, making a short strategy typically inappropriate for the long term. The inverse risk/reward relationship also makes short selling an inappropriate strategy for most investors.
Investments, Markets, and Terminology
Short selling can depress market prices of a security. Governments have restricted short selling during several major economic crises. Stopping short selling has not, however, been shown to help stabilize markets.
In the United States, initial public offerings cannot be sold short during their first 30 days of trading.
Short selling works only with fungible investments. When you sell a stock or a bond, you can replace it with another of the same and it doesn’t need to be the exact one. It doesn’t work if the investment is unique, such as real estate, where you can’t replace the original with another of its kind.
Short interest is the number of a company’s shares that have been sold short. It can also be expressed as a percentage of outstanding shares.
It is an indication of how the market perceives the near-term prospects for the stock, with a higher short interest indicating more bearish investors.
The short interest ratio is the ratio of shares sold short to average daily trading volume and is another useful indicator of relative pessimism for the stock’s near-term future.
A short squeeze results when investors drive up the price of a security, in an attempt to cover short positions. The increased purchases to cover these short positions lead to further increases in share prices, causing yet more short sellers to seek to cover their shorts and limit their losses.
Most investors will never be directly involved with short sales. There are valid reasons for considering a short strategy in a portfolio.
Markets do not only go up. Most investors, however, only make money when markets go up.
There is the potential for greater gain, albeit with greater risk, by incorporating short selling into the strategy.
An investor who feels strongly that a particular issue may decline in price can use a stop order to limit their losses, making a short strategy more palatable without the potential for unlimited loss.
More commonly, an investor who is heavily weighted in a sector may short a particular investment or go short through a pooled investment, such as an exchange-traded fund (ETF), to hedge against broader declines in that sector.
An investor may also short an investment they are also long in. This is known as going short against the box. An investor can use this strategy to lock in a gain on an investment they own without yet selling the investment. Having both long and short positions in the investment cancels the effect of future price changes.
An investor may want to do this for a variety of reasons, but it won’t typically help from a tax standpoint; the IRS generally considers the strategy to be a constructive sale of the asset.
An investor can use a put option as an alternative to taking a short position. A put option gives the investor the right, but not the obligation, to sell the stock at a future strike price.
A decline in the value of the underlying stock would place the put option in the money, making the investor profit from the price decline. This alternative does not have the same risk as taking a short position.
The Bottom Line
Short selling is not for everyone. All investors, however, should know what it is and be able to question increasing short interest in issues they own.
For some investors, short selling can be a valid strategy to seek near-term gains or to hedge existing positions, especially when they hold concentrations in a sector.
Selling short involves greater risk than actually owning securities does; the risks in short selling are theoretically unlimited.
Investors, however, can take steps to limit their risk.Many investors can hedge positions in other ways, including using puts. Shorting ETFs can also serve as a hedge without as much downside risk as shorting an individual security.
The risk of shorting an ETF is lower as it would require broader market movement for runaway price increases, the movement of an individual security has less impact.
There are also ETFs that work as the reverse of an index, effectively creating a short for that index. These pooled investments may offer a wider array of investors the opportunity to seek gains from negative price movements without taking on the relatively high risk of shorting individual securities.