How do you begin short selling as an investment strategy? A number of rules restrict which stocks may be shorted and the necessary conditions for shorting. This means you won’t always be able to short any stock you want, whenever you want. Working with an online brokerage service like Ally Invest ensures you have plenty of investment insights at hand.

Margin Requirements

You must hold in your account 100% of the security’s current market value. This is the cash you received from the initial short sale plus any increase which may have occurred to date. Because there is a liability attached to the receipt of the cash, you are not entitled to spend it. On top of that, there are standard margin requirements for short-stock transactions.

You already know you must hold the security’s entire market value. On top of that you must also hold 50% of the initial value of the short stock in cash and / or marginable securities if the strategy doesn’t go your way. That means you’ll typically need to have the equivalent of 150% of the stock’s value on hand at any time to help cover your risk. You are also subject to maintenance requirements throughout the life of the trade (usually at least 40% of the current value).

Margin calls: When The Trade Moves Against You

If the value of the stock you have shorted increases while your trade is open, you may need to pony up more funds or marginable securities to cover the additional risk. This is known as a margin call. Furthermore, if your holdings are not diversified and your account is too concentrated in a short position, your brokerage may impose higher amounts or additional restrictions.

Subject to Potential Buy-ins

A buy-in refers to the possibility that Ally Invest may call for the return of the shares. This means that you (the borrower) must buy the shares on the open market and return them to Ally Invest. If you don’t take action, we will step in and buy the shares for you. Often, this happens when the stock price is increasing and the original share owner wants to take some profits. This may also happen when there are fears of bankruptcy or in the event of takeovers. It’s entirely possible that you’ll get forced into an ill-timed exit against your will.

Minimum Balance for Margin Accounts

According to federal requirements, the absolute minimum balance for creating a new margin account is $2,000. At any point in time, however, the balance of a margin account must be at least 50% of the total value of the short position.

The mechanics of transacting a short sale

Entering your short position

Establishing a short stock position involves selling shares that you do not own in the open market. When you short the shares, you receive cash into your account, and you are obligated to buy the shares at a later date in order to close your short position.

When you feel bearish about a stock, enter a sell short order to initiate the transaction. After Ally Invest confirms the shares are available for shorting and you have sufficient assets in your margin account as collateral, the order is released to the market and the proceeds of the sale are credited to your account.

Ally Invest must be able to make delivery of the shorted shares, in what is known as a stock locate. Brokers have several ways to borrow shares in order to facilitate locates and make good on the delivery of the shorted shares. If they cannot locate them from their own customers, they may be able to arrange loans from custody banks and fund management companies; however, this service may come at a cost to the short seller. If this happens, the shares are likely hard-to-borrow. Some factors that can influence the availability of stock are high demand, small float and increased volatility of the particular security.

For the average Ally Invest client looking to short a stock, this is an ample supply. Occasionally, the number of shares held short rises to a point where the clearing firm may activate policies to make the stock harder to borrow in order to maintain their own supply, namely by implementing hard-to-borrow fees. If you open and close a short position intraday (not held overnight), you will not be subject to a fee. However, if you hold the position longer, a hard-to-borrow fee will be passed on to you.

The hard-to-borrow rate for a security can range from a fraction of a percent to above 100% of the principal value of the trade, depending on market demand. Should the fee rise above 3% while holding a short position, Ally Invest will attempt to advise you of this change and may close your position without prior notice, if necessary. You will be responsible for any hard-to-borrow fees and rate increases if they occur.

Exiting your short position

You can close the short position at any time when buying back the shares. This is called buying to cover. If the price has dropped during the borrowing period, you make a profit. If the price has increased, you’ll incur a loss.

Market liquidity

Access to market liquidity is crucial for any investor. When people say a market is liquid, they mean stocks can be traded rapidly at any time with other market participants. Without short sellers stepping in to provide additional liquidity during periods of market duress, trading activity would slow to a crawl in certain stocks – and slowing activity breeds even less activity later.

At the same time, if there are fewer ready and willing buyers and sellers in a specific stock, the difference between the bid and ask prices will widen. These wider spreads reflect the higher market risk that a stock will not be able to be traded quickly at nearly the same price.

When the market lacks both depth and breadth, the buying and selling process becomes strained. Stocks may become illiquid if they are not readily saleable due to uncertainty about their value, or the lack of a market in which they are regularly traded. Just like turbulence on an airplane, choppiness in markets makes for a rough ride. Because of this risk, many short sellers restrict their activities to heavily traded stocks where liquidity is usually readily available.

The need to minimize those potentially unlimited losses causes short sellers to buy if the stock is moving higher against them. As buyers overwhelm the sellers in the market, it becomes increasingly difficult to manage losses on short sales.

Learn from short-selling analytics

Traders use several key indicators to gauge whether a market is overpriced. On one hand, these indicators can be used to analyze a potential short sale or existing short position. On the other hand, they can be used by bullish traders as a type of contrarian indicator.

Short interest

This is the total number of shares held short in a given stock. It is often expressed as a percentage by dividing it by the total number of shares outstanding. These numbers are reported regularly.

In general, the higher the short interest, the more the sentiment is considered bearish. However, at a certain point, too much short interest becomes a contra-indicator, which is actually bullish. (Remember: all those shorts will eventually need to buy-to-cover.) Since short sellers are bearish and not bullish, they may monitor this number for potential exit points, or it may influence them to pass and move on to another potential trade.

Short interest ratio (days-to-cover)

This popular indicator refers to the number of short shares outstanding, compared to the average daily trading volume in the same security. If all of the activity in a particular stock was only short covering, and the stock still traded the same average daily volume, days-to-cover tells you how many days it would take for all the shares held short to be covered. The higher the ratio, the more days it would take to cover the short positions. This gives traders an indication of the potential buying pressure in a particular stock. The more days needed to cover, the more bullish the indication.

Not every source of financial data calculates short interest statistics in the same way. To tally short interest, Ally Invest uses the number of shares outstanding and the number of shares held short. Others may use the float instead of number of shares outstanding. (Keep in mind: a sizeable portion of a stock’s float is usually held in reserve by the company itself and not outstanding in the market.) Or they may use a method that provides a historical measure of short interest.

Learn More About Ally Invest