Not all stock trades are as simple as buying or selling. Several strategies can help enhance your gains, though they also come with increased risk. One such strategy is selling short.
Investors often use short selling to hedge their portfolios against potential losses in other stocks. However, speculators might short a stock anticipating a significant drop in its price to profit from the decline.
How selling short works
While most investors buy stocks with the expectation that their value will rise, some invest with the anticipation that a stock’s price will fall, potentially significantly. This strategy is known as short selling.
To sell short, you borrow shares you don’t own from your brokerage firm and place a sell order. The proceeds from this sale are held in escrow until you return the shares. You then wait for the stock price to drop. If it does, you buy the shares back at the lower price, return them to the firm (plus interest and commission), and pocket the difference.
For example, if you short sell 100 shares of a stock priced at $10 per share and the price drops to $7.50, you can buy back the 100 shares at the lower price, return them to the brokerage, and keep the $2.50 per share difference as profit—minus fees and commissions.
This process of buying back the shares to return them is known as covering the short position. In this scenario, since you sold the shares for more than the cost to repurchase them, you realize a net profit.
What are the risks?
The risk in short selling arises if the stock price increases instead of decreasing or if the decline takes longer than anticipated. Since you’re paying interest on the borrowed shares, the longer you hold the position, the more interest you accrue, which can erode your potential profit.
An even greater risk is if the stock price rises. In this case, you’ll have to spend more to repurchase the shares than you initially received from selling them, potentially resulting in significant losses.
Short squeeze
A short squeeze occurs when a heavily shorted stock begins to rise in price. Short sellers, trying to limit their losses, rush to cover their positions by buying back the stock. This surge in buying drives the price even higher, exacerbating the losses for those who shorted the stock.
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Buying warrants
A warrant offers a less risky way to speculate on a stock’s future price compared to short selling. It gives you the right, for a small fee, to buy a stock at a predetermined price within a specific period. Investors purchase warrants if they anticipate a stock’s price will rise.
For instance, if you pay $1 per share for a warrant that allows you to buy stock at $10 within five years, and the stock’s price climbs to $14, you can exercise your warrant, purchasing the shares at $10 each. You could then sell the shares for $14, making a profit of $3 per share ($14 – ($10 + $1)). For 100 shares, this amounts to a $300 profit.
Companies issue warrants when they intend to raise funds by offering new stock or selling shares they hold. Warrants can be traded on the market just like other securities. A “wt” next to a stock symbol indicates it’s a warrant. If the stock price is below the set price when the warrant expires, it becomes worthless. However, because warrants are relatively inexpensive and have longer durations, they remain actively traded.
FAILS TO DELIVER
The SEC’s Regulation SHO limits naked short selling, which involves selling short without ensuring access to the shares being shorted. Naked shorting can disrupt the settlement process, increase brokerage fees, and damage the value of the stock being illegally shorted.
Who’s the lender?
Short selling often increases during market booms when short sellers anticipate a forthcoming correction, particularly if economic growth doesn’t match the rapid rise in stock prices. Despite its bearish nature, short selling can signal increased trading activity, as short positions eventually need to be covered.
Brokers find stocks to lend for short selling by accessing their firm’s inventory, borrowing from other investors’ margin accounts, or tapping into shares held in institutional accounts like mutual funds or pension funds.
THE LONG AND THE SHORT
The opposite of selling short is going long on a stock. This strategy involves purchasing stock to hold in your portfolio until you decide to sell, either to lock in a profit or to limit potential losses. This is commonly referred to as having a long position or being long.
In options trading, the terminology shifts slightly. When you buy options, you are considered the long position, while the investor who sells options is the short position. Unlike stock trading, the number of long positions must equal the number of short positions in options trading.
There can be a lack of transparency when it comes to the ownership of shares that are loaned out. While shareholders may not always be aware that their shares have been borrowed, their ownership is not at risk. Brokers who facilitate short sales hold the proceeds from the sales in escrow until the shares are returned.
However, there are potential downsides for shareholders who lend out their shares. Any dividends received during the loan period are taxed at the regular federal rate, rather than the lower long-term capital gains rate for qualified dividends. Additionally, shareholders may lose their voting rights on corporate matters if votes occur while their shares are on loan.
These considerations have led some investors to limit their use of margin accounts unless they engage in substantial margin trading or short selling. Others may choose to deposit only non-dividend-paying stocks into their margin accounts to avoid these issues.
What Is Short Selling Stocks? Meaning And Examples by Inna Rosputnia
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