Investing in or trading on the expectation that the price of a stock or other asset will drop is known as short selling. This is a sophisticated approach best suited for seasoned traders and investors.

Investors or portfolio managers may use short selling as a hedge against the downside risk of a long position in the same or similar securities, or traders may use it as a form of speculation. Speculation is an advanced trading strategy that carries a significant risk. A more popular transaction is hedging, which involves taking the opposite position to lower risk exposure.

When engaging in short selling, an investor initiates a position by borrowing shares of a stock, bond, or other asset that they anticipate losing value. The investor then sells the borrowed shares to purchasers prepared to pay the going rate. The trader speculates that the price will drop further, and they can buy the shares at a reduced price before the borrowed shares are returned. Since the price of any asset might increase to infinity, there is an infinite risk of loss on a short sale.

Understanding Short Selling

When a seller engages in short selling, they often borrow shares from a broker-dealer to repurchase them at a profit should the price drop. A trader closes a short position by buying back the shares and returning them to the lender or broker, ideally for less than what they borrowed. Any interest or commissions that the traders must pay the broker charges.

A trader needs a margin account to initiate a short position, and while the position is open, they often have to pay interest on the value of the borrowed shares. The New York Stock Exchange (NYSE), the Federal Reserve, and the Financial Industry Regulatory Authority (FINRA) have established minimum values for the amount the margin account must maintain—the maintenance margin.1 If an investor’s account value falls below the maintenance margin, more funds are needed, or the broker may sell the position. FINRA is responsible for enforcing the laws and regulations governing registered brokers and broker-dealer firms in the United States.

The broker works behind the scenes to find shares that may be borrowed and returns them after the deal. Most brokers’ standard trading systems allow for the opening and closure of trades. Before permitting margin trading, the trading account must fulfill the requirements set out by each broker.

Why Would You Sell Your Short?

Hedging and speculating are the two main motivations for short selling. A speculator makes a pure price wager that the security will decrease. If mistaken, they will lose money by paying a higher price to repurchase the shares. Short selling is often done over a shorter time horizon. It is thus more likely to be an activity for speculation owing to the higher risks associated with using margin.

To hedge a long position, people might also trade short. To lock in winnings, you could sell short against your long positions, such as call options, if you possess any. Another option is to sell a stock strongly linked to or closely tied to the long stock position to reduce downside losses without quitting the long stock position.

A profitable example of short-selling

Consider a trader who predicts that the price of XYZ stock, now trading at $50, will drop during the following three months. They sold the 100 shares they borrowed to another investor. As a result of selling what they borrowed rather than owning, the trader is now “short” 100 shares. The short sale was only possible by borrowing the shares, which might not always be available if other traders have a large short position in the company.

A week later, the price drops to $40 when the business whose shares were shorted announces poor quarterly earnings. The trader settles the short position to replace the borrowed shares and purchases 100 shares for $40 on the open market. Based on the following calculations, the trader’s profit on the short sale is $1,000, less fees and interest on the margin account: $50 minus $40 = $10 and $10 x 100 shares = $1,000.

An illustration of a loss-making short sale

Using the example above, assume that the trader held onto the short position rather than closing it at $40 to profit from a further price drop. But the stock skyrockets when a rival moves in with a takeover offer of $65 per share to buy the business.

Based on the following calculations, the trader would lose $1,500 on the short sale if they decided to terminate the position at $65. $50 minus $65 = negative $15, and negative $15 times 100 shares = $1,500 loss. In this instance, the trader had to purchase the shares again at a much higher price to cover their position.

An example of hedging using short sales

Other than speculation, there is another practical application for short selling: hedging, which is sometimes seen as the more respectable and low-risk counterpart of shorting. Protection is the primary goal of hedging, not speculating for the sole purpose of making money. Although hedging is done to safeguard profits or reduce losses in a portfolio, most retail investors do not think about it regularly due to its high cost.

Hedging comes at two prices. In addition, there is the actual cost of hedging, including short-sale costs and protective options contract premiums. Another factor is the potential cost of limiting the portfolio’s upside if markets continue to rise. For instance, if a portfolio that closely tracks the Standard & Poor’s 500 Index (S&P 500) is 50% hedged and the index gains 15% over the following year, the portfolio would only realize about half of that gain or 7.5%.

Benefits and Drawbacks of Short Sales

Should the seller misjudge the direction of the price movement, selling short might be expensive. If a trader purchases stock, they can only lose their money if the price drops to zero.

However, a trader who shorts stocks risks losing much more than their initial capital. The lack of a price cap on stocks exposes investors to danger. In addition, the trader needed to finance the margin account to hold the stocks. Even in the best-case scenario, traders must still account for the margin interest cost when figuring out their earnings.

Advantages

• Potential for significant financial gains
• Minimal starting capital needed
• Possible leveraged investments
• Protect yourself from other assets.

Cons

• Possibility of infinite losses
• Margin account required
• Interest paid on margin
• Brief squeezes

If many other traders are shorting the company or the stock is lightly traded, a short seller may find it challenging to obtain enough shares to purchase when it comes time to terminate a position. On the other hand, sellers may find themselves in a short-squeeze situation if the market or a specific stock begins to soar.

However, there is a high return benefit associated with high-risk tactics. There is no exemption for short sales. The seller may profit handsomely from their investment if they accurately forecast price movements, especially if they employ margin to open the deal. Leverage is provided using margin, so the trader does not need to commit much of their cash upfront. When handled properly, short sales may be a cheap hedge that acts as a counterweight to other assets in the portfolio.

Novice investors should hold off on short sales until they have more trading expertise. Nevertheless, this is a safer tactic since there is less chance of a short squeeze when using exchange-traded funds (ETFs) for short sales.

Extra Things to Think About When Selling Short

Aside from the potential loss of capital on a bond or stock price increase, investors should consider other risks associated with short selling.

Shorting takes out loans.

Margin trading is another name for shorting. When you short-sell, you create a margin account, allowing you to borrow money from the brokerage company using your investment as security. Losses may spiral out of control since you must fulfill the minimum maintenance requirement of 25%, just as when you go long on margin. You must take out a margin call and either deposit additional money or close your investment if your account falls below this threshold.

Incorrect time

It may take some time for a company’s stock price to drop, even when it is overpriced. You risk paying interest, being called away, and receiving margin calls.

Brief squeeze

A short squeeze may also occur in a heavily shorted company with a high days-to-cover ratio and a short float (more later). When a stock starts to climb, short sellers cover their bets by repurchasing their short holdings, known as a short squeeze. This purchase might start a feedback cycle. As a result of increased demand for the shares, the stock rises, and more short sellers cover their bets or buy back their shares.

Risks related to regulations

In some cases, regulators may prohibit short sales in a particular industry or market to prevent panic and undue pressure to sell. When a stock price spikes unexpectedly, the short seller may be forced to cover their short holdings at significant losses.

Opposing the trend

Historical evidence indicates that equities typically have an upward trend. Most equities see price appreciation over time. Inflation or the pace of price growth in the economy, should, in any case, raise a company’s stock price, even if it barely improves over time. This indicates that shorting is a wager against the market’s general trajectory.

The Price of Intact Selling

In contrast to purchasing and retaining stocks or assets, short selling entails substantial expenses on top of the customary brokerage fees. Among the expenses are:

Interest margin

When trading stocks on margin, margin interest may add up to a substantial amount. The interest due on short transactions may build up over time, mainly if short positions are held open for a long time since short sales are only possible via margin accounts.

Costs associated with borrowing stocks

Shares with high short interest rates, restricted market liquidity, or any other factor that makes them challenging to borrow have the potential to incur significant “hard-to-borrow” penalties. The charge is prorated for the number of days the short trade is active and is based on an annualized rate that may vary from a tiny fraction of a percent to over 100% of the short trade’s value.

Since the hard-to-borrow rate is subject to significant daily and even intraday fluctuations, it may not be possible to determine the precise charge amount in advance. Typically, the broker-dealer charges the fee to the client’s account at the end of each month or when the short transaction is closed. It may significantly reduce the profitability of a short transaction or amplify losses if it is substantial.

Other payouts, such as dividends

The party from whom the stock was borrowed must receive dividend payments on the shorted shares from the short seller. They have to provide the lender with the interest or coupon payable on bonds that have been shorted. Due to unforeseen circumstances involving the shorted shares, such as share splits, spinoffs, and bonus share issuance, the short seller is also liable for payments.

Metrics for Short Sales

A stock’s short-selling activity may be monitored using two metrics:

The short interest ratio (SIR), also known as the short float, calculates the proportion of shares that are currently shorted to the total number of shares available or “floating” in the market. Falling stocks or equities that seem overpriced correlate with a very high SIR.

The total shares held short divided by the average daily trading volume of the company yields the short interest-to-volume ratio, sometimes referred to as the days-to-cover ratio. Another sign that a stock is in trouble is a high days-to-cover ratio.

Investors may determine if the general mood toward a stock is bullish or pessimistic by using both short-selling measures.

For instance, the energy divisions of General Electric Co. (GE) started to negatively impact the company’s overall performance in 2014 after the drop in oil prices. As short sellers started anticipating a drop in the stock, the short interest ratio increased from less than 1% to more than 3.5% in late 2015. GE’s share price peaked at $33 per share by the middle of 2016 and started to drop. In February 2019, GE’s share price dropped to $10, meaning that investors fortunate enough to short the stock close to its peak in July 2016 would have made $23 a share.

Regulations for Short-Selling

The U.S. government regulates short sales in the country. The Securities Exchange Act of 1934 established the Securities and Exchange Commission (SEC). The primary law regulating short selling is Regulation SHO, enacted in 2005 as an amendment to earlier regulations. According to Regulation SHO, short sales are only permitted in tick-up or zero-plus tick markets, which means that the security price must be rising at the time of the short sale.

The location requirement is one of Regulation SHO’s other essential elements. Brokers must find a party willing to lend the shorted shares, or they must have excellent cause to think that the shares might be borrowed before they may proceed with a short sale. This stops investors from selling shares they haven’t borrowed, a practice known as naked short selling.

The SEC may also temporarily prohibit short sales of certain stocks if specific criteria are met, such as high market volatility.

The SEC published new regulations in October 2023 to enhance short-selling transparency. According to the law, individuals must notify the SEC of their short holdings, and companies that lend shares for short sales must notify FINRA of this activity.

These new regulations reflect heightened monitoring of short selling, especially after the 2021 GameStop (GME) meme stock scandal, in which hedge funds shorted the firm and suffered losses due to retail investors driving up the stock price. The SEC intends to provide aggregate stock-specific statistics later, giving investors a complete view of short bets throughout the market. Nonetheless, a few hedge firms worry that these regulations will reveal investors’ tactics.

Rules governing short sales outside of the US

• Laws governing short sales differ in non-US nations.
• European Union: The European Securities and Markets Authority (ESMA) regulates short sales inside the EU. Under the EU’s two-tier approach, positions above 0.2% of issued shares must be reported to authorities, and positions surpassing 0.5% must be revealed to the public.
• United Kingdom: The regulatory agency regulating short sales is the Financial Conduct Authority (FCA). In general, the rules resemble those of the European Union.
• Hong Kong: The Securities and Futures Commission (SFC) regulates short sales in Hong Kong. Only specified securities may be sold short and must be supported with borrowed shares. Illegal shortselling is done naked.
• Japan: The Financial Services Agency (FSA) in Japan regulates short sales. Short selling is permitted only at a price more significant than the most recent market price.
• Australia: Any short holdings that reach $100,000 or 0.01% of the total shares must be registered, according to the Australian Securities and Investments Commission (ASIC) rule.

Optimal circumstances for short sales

When it comes to short sales, timing is everything. Generally speaking, stocks fall far more quickly than they rise, and a significant gain in the market might be erased in a matter of days or weeks in response to an earnings miss or other negative occurrence. As a result, the short seller must timing the short sale almost precisely. If you enter the trade too late, a significant portion of the stock’s slide may have already happened, which might mean a significant opportunity cost for missed earnings.

Nevertheless, given the associated expenses and possible losses—which would soar if the stock rose quickly—entering the trade too soon might make it challenging to maintain the short position.

The likelihood of a successful shorting increases at specific periods, such as:

In a market downturn

A bear market is when a stock market or industry is dominated. Therefore, during a deepening bear market, traders who adhere to the theory that “the trend is your friend” are more likely to make good short-sale transactions than during a robust bull period. Because they may benefit handsomely from sudden drops in the market, short sellers thrive in conditions such as the global bear market of 2008–2009, which was rapid, comprehensive, and profound.

When the fundamentals of the market or stocks are declining

A stock’s fundamentals might worsen for several reasons, such as declining revenue or profit growth, growing business problems, and rising input prices that pressure margins. Indicators indicating a potential economic slowdown, adverse geopolitical events such as a war threat, or bearish technical indications such as new highs on declining volume might all be signs of weakening fundamentals for the whole market.

Skilled short sellers could instead hold off on entering short positions anticipating a decline, waiting until the bearish trend is verified. This is due to the possibility that, as is usually the case in the latter stages of a bull market, a company or market may move upward for weeks or months despite weakening fundamentals.

Technical data supports the negative trend.

Multiple technical signs confirming the negative trend may increase the likelihood of success for short sales. A collapse below a significant long-term support level or a bearish moving average crossing, such as the death cross, might be examples of these signs. When a stock’s 50-day moving average drops below its 200-day moving average, this illustrates a bearish moving average crossover. The price of a stock averaged over a predetermined length of time is called a moving average. A new trend in the price may be indicated if the current price breaks the average, either upward or downward.

Appraisals rise to high levels amid widespread optimism.

Periodically, prices in specific industries or the market may rise very high because of widespread optimism about the long-term outlook for such industries or the overall economy. This stage of the investing cycle is known by market experts as “priced for perfection,” as investors will inevitably experience disappointment when their high expectations are not realized. Experienced short sellers could wait until the market or sector turns over and starts its declining phase rather than jumping in on the short side.

The economic ideas of renowned British economist John Maynard Keynes are still used today. Keynes famously observed, “The market can stay irrational longer than you can stay solvent,” which applies primarily to short sales. The best moment to engage in short selling is when all of the criteria above coincide, although this may be difficult to anticipate.

The Image of Short Selling

There are instances when short sellers face criticism and are seen as unscrupulous businesspeople who want to destroy firms. But in actuality, short selling helps keep poor stocks from gaining hype and overconfidence by bringing liquidity to the market—that is, enough buyers and sellers. Asset bubbles that cause market disruptions are one example of this advantage. Assets that cause bubbles are sometimes hard or even impossible to short, as was the case with the mortgage-backed securities (MBS) market before the 2008 financial crisis.

An authentic source of information on the mood of the market and the level of demand for a stock is short-selling activity. Investors might be unprepared for unexpected news or unfavorable underlying developments if they lack this knowledge.

Unfortunately, the actions of unscrupulous speculators have damaged the reputation of short selling. These dishonest people artificially deflated prices and conducted bear raids on susceptible equities using derivatives and short-selling techniques. Although most such kinds of market manipulation are prohibited in the United States, they still sometimes occur.

Put options are a fantastic substitute for short selling since they allow you to benefit from a decline in the stock price without requiring capital.

An Actual Case of Short selling

Unexpected news stories have the potential to start a short squeeze, forcing short sellers to purchase at any price to meet their margin needs. For instance, during a historic short squeeze in October 2008, Volkswagen rose to the top of the global publicly listed firm valuation list.

Investors were aware in 2008 that Porsche was attempting to acquire a controlling stake in Volkswagen. Short sellers significantly shorted the shares, anticipating that the stock would decline in value after Porsche took over the firm. But when Porsche unexpectedly disclosed that they had secretly purchased over 70% of the business via derivatives, short sellers snapped up shares to cover their short positions, setting off a tremendous feedback cycle.

Because Porsche held 70% of Volkswagen and a government body owned 20% of the company, short sellers were disadvantaged because relatively few shares were available to purchase back the stock. In essence, the stock price shot up from the mid-€200s to over €1,000 due to an overnight explosion in both the short interest and days-to-cover ratio.

However, a short squeeze usually wears off fast, and Volkswagen’s stock dropped back to its typical range in months.

Why Must Short Sellers Take Out Share Loans?

A short seller needs to find some of the outstanding shares of a corporation since there are only a certain number of them to sell. Therefore, the short seller borrows the shares from an existing long, and interest is paid to the lender. One’s broker often assists with this procedure in the background. The interest cost to sell short will be more significant if there aren’t enough shares for shorting.

Is it wrong to short-sell?

While some believe it is immoral to gamble against the market, most financial experts and economists agree that short sellers increase market efficiency by bringing liquidity and price discovery.

Can I use my brokerage account to sell short?

Many brokers permit short sales in individual accounts, but you must apply for a margin account first.

A Short Squeeze: What Is It?

Relatively small increases in the stock price might result in far more significant losses since shares are sold on margin in short sales. To complete the trade and prevent future losses, the short position holder must purchase back their shares at the current market levels. If many others are attempting to do the same thing, this requirement to acquire may help drive the stock price even higher. This may eventually lead to a brief crush.

The Final Word

In a declining market, short selling enables traders and investors to profit. To sell their shares on the open market and repurchase them later at a reduced price, bearish investors might borrow shares on margin.

Many economists contend that the opportunity to sell short increases market efficiency and may even serve as a stabilizing influence despite criticism that it is a gamble against the market. For inspiration on trade ideas, technical traders and analysts often examine a stock’s short interest and other measures about short positions. Margin calls, however, have the potential to compress massive short holdings. Requiring purchases to settle short positions can increase prices and intensify a rally, exacerbating losses for short sellers.

Conclusion

• When an investor borrows a security and sells it on the open market to repurchase it later for less money, this is known as short selling.
• Short sellers wager on and benefit from a decline in the value of an asset. Long-term investors, on the other hand, want a price rise.
• The risk/reward ratio of short selling is high; although it may provide substantial profits, losses can compound rapidly and indefinitely, often leading to margin calls.