Shorting a Stock
Shorting a stock, also referred to as short selling, is an investment strategy that lets you profit from falling stock prices. For new investors, this may seem counterintuitive, but the great thing about the stock market is the flexibility that allows you to make trades that reflect both positive (bullish) and negative (bearish) viewpoints.
What Does It Mean to Short a Stock?
A stock short happens when an investor borrows a stock via a brokerage firm and immediately sells the stock to someone else. Also known as short selling, this strategy is often pursued when the price of a stock is expected to fall.
A price decline allows the short seller to buy the stock at a lower price than the price at which it was sold. The acquired stock is used to settle outstanding debt. Then, the short seller can pocket the difference between the price at which the stock was initially sold and the price at which it was subsequently purchased.
Why Investors Do It
As hinted at above, the potential to make a profit is the primary reason investors short stocks. The investment strategy is particularly popular with active traders who value the ability to make bets on both rising and falling stock prices. For them, the greater the chance for a good return on investment, the better — as it presents more chances to make profitable trades.
Another reason investors short stocks is to hedge existing exposures. By implementing short positions that profit when stock prices decrease, these investors can offset the downside risk associated with previously purchased stocks. Of course, the shorted stocks must be highly correlated with the stocks held.
How Does Stock Shorting Work?
The easiest way to understand stock shorting and how you might incorporate it into your own personal finance situation is with a simple example involving basic numbers. The example that follows provides a high-level overview of how stock shorting works, but keep in mind that we’ve left out costs for brokerage commissions, interest expenses and lending fees.
Assume you have a bearish outlook (you think the stock will go down) on Netflix Inc. (NFLX), and you believe its stock price is due for a sharp decline in the next 90 days. You borrow 100 shares of NFLX via your brokerage firm at $200 per share, and then you immediately sell the shares to another investor.
Short Sale Proceeds = 100 * $200 = $20,000
Just as you expected, over the next 60 days, NFLX declines by 25% to reach $150 per share. You decide it’s time capitalize on your intuition, so you buy 100 shares of NFLX at $150 per share.
Total Acquisition Cost = 100 * $150 = $15,000
The purchase you made in Step 2 automatically settles the debt you owe to the brokerage firm by returning the 100 NFLX shares you borrowed. At the same time, you can tally up the profit you made on the short sale.
Short Sale Profit = $20,000 – $15,000 = $5,000
This is a simplified example. Trading a stock often involves commission expenses, while borrowing a stock involves interest expenses plus other fees. Additionally, any dividends you receive for borrowed stock must be given back to the lender.
In order to short a stock, you need to have margin trading enabled on your brokerage account. This feature allows you to borrow money to facilitate trades. The ability to do margin trading is relatively easy to obtain, but your brokerage firm must look at your investment experience and your ability to pledge collateral before they will award it.
Once the margin trading feature is enabled, you are free to trade with borrowed money, but you must maintain an appropriate amount of collateral — known as margin — in the account. The collateral can take the form of cash or equity in the financial securities held in the account.
Trading on margin comes with a cost; you must pay interest on any money borrowed. For shorted stocks, you may also be required to pay a fee to the brokerage for arranging the transaction, which is commonly referred to as the cost of borrow.
What Are the Advantages to Shorting Stocks?
Beyond the considerations we’ve already discussed, there a number of other advantages associated with shorting stocks, including the following:
- Profit-oriented flexibility
- Short selling provides investors with flexibility, allowing them to profit on a stock’s decline. Traders are able to break from traditional, long-only trading patterns and capitalize on bearish views. Ultimately, it broadens the investing toolkit, offering more opportunities to make money.
- Minimalization of investment
- Because a short sale entails leverage, the upfront investment is relatively modest. However, you must maintain adequate margin in your account at all times.
- Enhanced liquidity
- Short sellers provide liquidity for buyers, which supports the orderly functioning of stock markets.
- Risk management
- Shorting stock can be an effective way to hedge risk. By implementing short positions, an investor can offset existing long positions, thereby reducing volatility and putting a floor on potential losses.
What Are the Disadvantages to Shorting Stocks?
In addition to the costs associated with trading on margin, let’s go over some of the main disadvantages to shorting stocks:
- Unlimited downside exposure
- The biggest disadvantage of shorting stock is the unlimited downside of the trade. If the price of a shorted stock rises, rather than falls, you’ll lose money. The loss will increase as the price continues to rise, and this could continue
- Short squeeze exposure
- While a shorted stock has theoretically unlimited risk, a short position will usually be closed out as losses mount. This is especially true with a short squeeze, which occurs when a shorted stock’s price rises rapidly and short sellers scramble to buy the stock and cease the hemorrhaging. All of the buying puts additional upward pressure on the stock price and amplifies loss potential.
- Uphill battle
- As history shows, the stock market goes up with time. Volatility may abound over the short-term, but the aggregate, long-run trend is undeniably “up and to the right.” Unfortunately, this is the wrong direction for short sellers. As a result, the only way to make money shorting stocks is through shrewd selectivity and great timing. Unfortunately, very few people can consistently make the right calls over extended periods of time.
- Trading costs
- Short selling is more costly than placing simple buy and sell stock trades. This is attributable to the interest and fees you must pay to your brokerage firm to facilitate these special transactions. Over time, the fee drag is considerable. This, coupled with the uphill battle aspect described above, makes shorting stocks a very difficult endeavor over the long term.
Is It a Good Idea to Short Stocks?
Stock shorting is a controversial subject, and short sellers receive a lot of criticism. Most commonly, they are accused of harming businesses, manipulating markets and sowing economic pessimism to generate a profit.
However, by and large, these criticisms are flawed.
Short sellers play an important role in stock markets, bringing perspectives that can temper unbridled enthusiasm, expose questionable accounting practices or simply uncover poorly run companies. Ultimately, they inform equilibrium prices and help to ensure that stock markets operate with a high degree of efficiency and transparency.
Alternatives to Shorting Stocks
There are two common alternatives to stock shorting — buying put options and selling futures contracts. Put options are widely applicable to individual stocks, but futures contracts are largely associated with stock indexes such as the Standard & Poor’s 500 index (S&P 500). Both investment strategies carry less downside risk than shorting a stock, but they also have their drawbacks, as described below.
- A put option gives you the contractual right, but not the obligation, to sell a stock at a predetermined price at any time before a specified date. For example, if you buy a put option on a stock with a strike price (sell price) of $100 and the stock drops to $80, you can exercise your option to sell it for $100, yielding a gain of $20. That said, the gain realized is net of the cost, or premium, of the option. During volatile times, the cost of the premium can be considerable.
- A futures contract is a standardized agreement between two parties that agree to exchange a specific quantity of an asset on a stated future date at a specified price. Entering into such a contract involves a fee that is paid to the dealer who facilitates the transaction. Downside exposure is limited, but the amount of money required to enter into a futures contract can be significant, depending on the exchange utilized.
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- Financial Industry Regulatory Authority Inc. Purchasing on Margin, Risks Involved with Trading in a Margin Account. Retrieved from https://www.finra.org/investors/learn-to-invest/advanced-investing/purchasing-margin
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