Many successful traders profit from rising stock prices. However, some people use a tactic known as short selling to profit from falling stock prices.
Short selling is borrowing from your brokerage security whose price you believe will decline and selling it on the open market. Your objective is to repurchase the same stock later, hopefully at a lower price than you sold it for initially, and pocket the difference after repaying the initial loan.
Assume a stock is now trading at $50 per share. You borrow $100 and sell it for $5,000. When the price drops to $25 per share, you buy 100 shares to replace those you borrowed, earning $2,500.
Short selling may appear simple, but this type of speculative trading is fraught with danger. Here’s a closer look at how it works—and what you should think about before jumping in.
Starting Over
You must first open a margin account to hold qualified bonds, cash, mutual funds, and/or stocks as collateral because you are borrowing shares from a brokerage business. You’ll be charged interest on the value of the outstanding shares until they’re returned, just like any other type of borrowing (though the interest may be tax-deductible). Interest rates can vary dramatically—you may be able to short the most liquid shares for free, while the least liquid shares may come with an annualized interest rate of more than 100% of the position’s value—and even alter abruptly if the shares become more or less liquid. Interest is calculated daily at the current rate and taken from your account on a monthly basis.
(It’s also worth remembering that before you can make a short sale, your brokerage must have a “locate” for the securities you’re interested in. This is a regulation requirement designed to prevent “naked shorting,” which occurs when a trader seeks to sell borrowed shares without actually taking delivery of them. Before you can short security, your broker must have a reasonable belief that it can be borrowed and delivered on a specified date. Shorting in such a situation may result in your brokerage closing your trade, perhaps leading to severe losses or fees.)
After you’ve opened and funded your margin account, you may begin looking into potential short-sale candidates. To identify short-sale targets, traders often employ one or more of the following methods:
- Fundamental analysis: Examining a company’s financials can help you evaluate whether its stock is likely to fall in value. Some traders, for example, look for companies with diminishing profits per share (EPS) and sales growth when looking for short-sale opportunities, with the idea that the company’s share price will follow suit.
- Technical Analysis: Patterns in a stock’s price movement might also assist you to determine if it’s on the verge of a decline. When a stock falls through a sequence of lower lows while trading at increasing volumes, this could be an indication. Another example is when a stock looks to be losing steam after regaining the upper range of its trading pattern.
- Thematic: This strategy involves betting against companies whose business strategies or technologies are regarded obsolete (think Blockbuster Video), which can be a longer game but can pay off if your forecast is true.
Making a trade
Before you begin, as with every transaction, you should choose your entry and exit locations. You could also consider placing a stop order to assist minimize your losses if the deal goes against you.
In general, there are two types of stop orders that may be useful:
- If the stock price rises to or above the stop price, a market order is issued to buy back the shares at the next available price.
- Trailing buy-stops establish a stop price that follows, or “trails,” the stock’s lowest price by a percentage or dollar amount you designate. A buy market order is triggered if the stock rises above its lowest price by the trailing or more. If the price falls, the stop is reset to a lower level.
However, neither technique ensures that the order will execute at or near the “stop” price you choose, and the stop order may result in severe losses if the price goes up.
Here’s an example. Assume stock XYZ just fell from $90 a share to $66 before rebounding to $84, and you believe it is due for another drop. You may decide on the following trade plan after reviewing company fundamentals and analyzing recent price movements:
Only short the stock if the price goes below $80 per share.
Set your buy-stop order at $84 to restrict your potential loss to $4 per share.
Your stake should be closed out at or below $74 per share.
Recognizing the dangers
There are various dangers associated with short selling:
- Potentially endless losses: When you acquire stock (have a long position), your downside is limited to the amount you invested. However, when you short a stock, its price can continue to rise. In theory, this means there is no cap on the amount you could spend to replace the borrowed shares.
For example, suppose you open a short position on 100 shares of stock XYZ at $80 and the stock increases to $100 instead of declining. You’ll have to spend $10,000 to repay your borrowed shares, resulting in a $2,000 loss. Stop orders can help limit this risk, but they are far from foolproof.
Short-seller losses can be more severe during a short-squeeze, which occurs when a heavily shorted company unexpectedly rises in value, causing a cascade of further price increases as more and more short-sellers are obliged to buy the stock to close out their holdings. Each wave of buying drives the stock price to rise, causing anyone holding a short position to suffer.
- An unexpected increase in fees. As previously stated, the cost of borrowing a stock fluctuates in reaction to supply and demand factors. For example, you could log out one night with a short position earning 20% interest, only to wake up the next day to find it has risen to 85%. As a result, you may discover that keeping your position available no longer makes sense. Even worse, if both the value of the stock you’ve shorted and the related interest rate rise at the same time, your cost to carry skyrockets.
- Dividend Payments: Payments are made in three installments. Short sellers are not entitled to dividend payments on shares borrowed. In fact, any dividends paid will be taken from the short-sellers account and delivered to the stock’s owner on the pay date. To avoid having to pay, some short sellers choose to close their short positions before the stock’s ex-dividend date. (As a reminder, the ex-dividend date is the first day on which a stock’s price no longer contains the value of a declared dividend. This is because the value of the next dividend payment is payable to the owner of the shares.)
(Schwab StreetSmart Edge® clients can see both borrowing rates and availability for certain shares by adding them to their watch lists. Simply go to the “Actions” drop-down menu and select “Columns & Settings.” Check the “Short Sell Borrowing Rate” and “Short Sell Availability” boxes in the “Company Info” section.)
- Calls on the margin. If the value of the collateral in your margin account falls below the minimum equity requirement—usually 30% to 35% of the value of the borrowed shares, depending on the firm and the specific securities you own—your brokerage may require you to deposit more cash or securities to make up the difference right away.
For example, assuming a 30% equity requirement ($8,000 x.30), you’ll need $2,400 in your margin account as long as your 100 shares of stock XYZ remain at $80 per share. If the stock suddenly climbs to $100 per share, you’ll require $3,000 ($10,000 x.30), which will necessitate an urgent infusion of $600 into your account, which you may or may not have.
If you do not satisfy the margin call, your brokerage firm may shut out open positions to bring your account back up to the required minimum.
Exercise cautious.
Short selling, at its most basic, entails betting against individual firms or the market, which may offend some investors.
However, if you have a strong belief that a stock’s price will fall, shorting can be a successful way to act on that belief—as long as you are aware of the risks.
