Short-selling involves borrowing a security you expect to fall in value so that you can immediately sell it, wait for the price to drop, and then buy it back at a lower price. The difference between the price you sell the stock at and the price you repurchase the stock at, less associated costs, is your profit or loss. Short-selling is a sophisticated and highly risky trading strategy that should only be used by investors who fully understand the associated risks.
What is short-selling?
Short-selling is an advanced trading strategy that goes against “traditional” investing. “Traditional” investors purchase securities with the idea of “buy low, sell high,” anticipating that the security will increase in value. Short-sellers, on the other hand, aim to benefit from an anticipated drop in a security’s price. The most common type of security shorted is equities or stocks; however, ETFs and bonds can also be sold short.
In order to short-sell, you’d need a margin account. And, more importantly, you’ll want to do plenty of research before trading. Short-sellers generally look for companies they believe are overvalued. When they identify a security they want to sell short, they borrow the security and then immediately sell the security in the market. When doing research, indicators an investor may look for are firms with a flagship product that hasn’t taken off with consumers, or one with a stock that’s under-performing relative to other companies in the same sector. They might also look for sectors likely to experience challenges. There are many different variables and considerations, which is why thorough market research is critical before trying to short a position.
To close their position, the investor must buy back the security in the open market and return the security to the lender. In the best-case scenario, they buy the shares back at a lower price and pocket the difference - less associated costs. If the security’s price goes up instead of down, the investor is forced to buy back the security at a higher price and will incur a loss. In theory, these losses can be infinite as the stock price can perpetually increase. Regardless of how large these losses are, the investor is obligated to return the security to the lender.
Example of short-selling
Let’s say an investor has been researching ABC Company for months and thinks the stock price will drop soon. They borrow 1,000 shares from the lender at a price of $50 per share. They then sell the shares for $50,000. Here’s what happens when the position is closed, and the investor returns the shares to the lender. If:
The stock price goes down: If ABC Company’s share price drops by 20% to $40 per share, the investor buys 1,000 shares at a total cost of $40,000. The difference ($10,000) between the amount they originally sold the shares for ($50,000) and the amount they repurchase the shares for ($40,000), minus associated costs, is their profit.
The stock price goes up: If ABC Company’s share price increases to $75 per share, the investor buys back 1,000 shares at a total cost of $75,000. The difference between the amount they originally sold the shares for ($50,000) and the amount they repurchase the shares at ($75,000) results in a loss of $25,000 plus associated costs.
Why do you need a margin account to short-sell?
To short sell, you need to borrow securities which requires a margin account. The assets in the account are pledged as collateral against the amount borrowed to short-sell.
While holding a short position, an investor must have funds in their account to meet the minimum margin requirement. The Canadian Investment Regulatory Organization (CIRO), which regulates investment dealers in Canada, sets the minimum margin requirements for securities. Brokers are allowed to set their own margin requirements given they are higher than the minimums set by CIRO.
So as an example, if an investor decided to short 100 shares of ABC Company, which has a current market value of $10 per share and the minimum margin requirement is 30%, in order to sell the security short, they would need to have at least $300 in their margin account. The margin requirement of $300 plus the proceeds of $1,000 from the short sale are held in the account as collateral, for a total of $1,300.
If the price of the security rises, the investor could be subject to a margin call. A margin call is a demand from their broker to fund their account to meet minimum margin requirements. If they receive a margin call, they’ll need to fund their account by closing the position, or transferring cash or securities to their margin account.
Benefit, downsides, and risks of short-selling
Short-selling can be lucrative for investors who predict the securities performance correctly; however, short selling can come with significant downsides and risk.
Here are some of the benefits:
Profit Potential. If the security price decreases drastically, the profits from a short sale can be significant.
Hedging. Short-selling is often used by sophisticated investors to hedge against potential losses from other investments. For example, short selling can be combined with various options strategies, which can reduce the investors overall exposure and risk.
Diversification. Diversifying your portfolio reduces risk by using different strategies and spreading investments across asset classes, sectors, geographic regions, etc. Short-selling is another strategy that can be added to your portfolio to increase diversification.
Here are some of the downsides and risks:
Loses are infinite. The potential profits of short-selling are capped at the price the security is borrowed at. This is because the price of a security cannot fall below $0. For example, if you borrow the security at $50, and the price falls to $0, your maximum profit is $50/share. The potential losses, however, are unlimited, because the securities price can, in theory increase infinitely. The higher the securities price, the more it costs you to buy back the security, and the greater your losses.
Margin calls. As noted above, if your margin account does not meet the minimum margin requirements, you will be subject to a margin call, and will need to fund your account. If you do not have access to additional funds, you may be forced to close your short position prematurely.
Short squeezes. A short squeeze occurs when a heavily shorted stock increases in price and short sellers are forced to buy back the security at a higher price . This heightened demand further increases the price and can cause significant losses for the short seller.
Costs. Short selling comes with various costs, some of the applicable costs are as follows:
Cost to borrow. When you short a security, you borrow shares. Generally, you pay a fee for this. The amount can vary and is often based on the securities availability and demand.
Dividends. If the company of the shorted security pays a dividend, you are responsible for paying those dividends to the lender.
Commissions. Some brokerages charge a commission when you buy and sell securities.
As you might see, short-selling can have significant downsides you need to be prepared for. Because of the high risk nature, short-selling is generally used by sophisticated investors.
