What is Short Selling?
Short selling? Shorting a stock? What are the types of strategies? Do I need a margin account? How does all this work? Interested in learning more? Then read on.
Introduction to short selling
Short selling may be used by experienced investors who seek to generate a profit when the price of a stock goes down. Typically, investors buy stocks they think will go up in price, allowing them to sell it at a higher price and keep the difference as profit. This is called going long. Shorting a stock, or short selling a stock, is the opposite. It’s what investors do when they think the price of a stock will go down.
With short selling, it’s about leverage. Investors sell stocks they’ve borrowed from a lender on the expectation the price will drop. The hope is to rebuy and replace the stocks they borrowed at a lower price. The difference between the price they sell the stock at, and the price they buy back the stock at, is the profit.
Keep in mind that you are paying interest to your brokerage, which will reduce the profit you earn on the short sell. However, with short selling comes additional rules, risks and expenses beyond standard self-directed investing.
What is a margin account?
Before attempting to short sell stocks, you’ll need a margin account.
You must apply and qualify for a margin account in the same way you would for a loan, since you need to prove that you can and will pay back the money you’re borrowing. Since you’re leveraging the brokerage’s money, they want to know that you have the ability to cover your loss, should your trade lose money.
Margin accounts let you borrow money against the securities you already own to buy additional securities. So, when you buy a stock in a margin account, you can choose to only pay a portion of the total stock price and borrow the rest from your brokerage. This is called “buying on margin”.
You can learn more about margin accounts, along with additional requirements and considerations for how they work, here.
How does short selling work?
Stock prices fluctuate all the time and short selling may be a way for investors to take advantage of negative fluctuations. If it is believed that a price of a certain stock is likely to drop, one may consider taking a short position on that stock, with the aim of taking profit from the drop.
So how does it work?
Short selling involves borrowing shares of a particular company from a lender (your brokerage) and selling them in the open market. Ideally, you then trade the shares you borrowed at a lower price.
The difference between what you originally sold the shares for, and the cost to replace them later, is your profit (minus any fees and margin account requirements, of course).
Here is a very simplified example: let’s say you borrow a stock from your brokerage company and sell it for $100. If the price of that stock drops to $80, you can buy it back at that price, return the stock to your brokerage company, and keep the $20 difference as profit.
After you short the stocks, your brokerage may require you to close the position at any time, as they may no longer be able to lend you the shares. This is known as a “forced buy-in”.
Benefits and disadvantages of short selling
Potential benefits of short selling stocks:
- Potential profit to be gained in the short-term, if or when stock prices go down.
- May be used to balance out other risks within your portfolio.
- Using margin provides leverage, so you don’t need to put up as much capital for your initial investment.
- If done carefully, short selling may be a way to hedge (a strategy to offset the risk of unfavorable price movements).
Disadvantages of short selling stocks:
- Carries higher risk.
- Involves higher trading costs than regular stock trading (i.e., margin interest, stock loan fees, etc.).
- Your firm may require a “forced buy-in”.
- Potential for unlimited loss, since there’s no cap on how high the price of the stocks you borrowed (and the cost of replacing them) can go.
- Short sellers are responsible for dividend charge-backs and any other distributions while they are short.
- There are securities which cannot be short sold, including:
- Securities trading under $1 (one dollar).
- Nasdaq Bulletin Board and Pink Sheet Securities.
- U.S. Securities that are not on the Protected List.
- Securities on the credit watch list with 0 loan value.
How to short a stock
Here’s a high-level overview of how the process of shorting stocks typically works:
- Apply and qualify for a margin account with your brokerage.
- Next, apply and qualify to add short selling to your margin account.
- Determine which stock you want to short.
- Place your sell order specifying it is a short sell.
- Once the order executes, proceeds are deposited in your account.
- Close your trade by “buying to cover” or “buying to close” a short position. “Buying to close” is a term primarily used by options traders and refers mainly to options, whereas “buying to cover” typically refers only to stocks.
- Return the shares you borrowed to your brokerage.
While there is no set limit on how long you take to replace the shares you borrowed, your lender can force you to close the position and replace the shares you borrowed. This is usually done when the position is moving in the opposite direction of the short and creating heavy losses, putting the likelihood of the shares being returned in jeopardy.
Though the process may seem simple, it’s important to note that it could be time consuming, particularly likely during the applying and qualifying step.
Remember, most investors aren’t comfortable with short selling as a strategy, since the general expectation is that stock value will increase.
If you’re an investor looking with more of a long-term strategy in mind, buying stocks may be a much less risky path for you to consider.
If you are still interested in short selling, you can get started by applying for a margin account with TD Direct Investing.