Risks and benefits of short selling a stock
- Jan. 28, 2022
- 8 min read
What we'll cover
The definition of short selling
The risks and benefits of short selling
How short selling may fit your financial goals
Have you always been a long-term investor but want to try something new? Or maybe you're just getting started in the markets and are feeling empowered to take on short selling right out of the gate. There's one word that’s most important when you want to start short selling: education. It's important to really understand short selling before you dive in.
What is short selling?
Short selling involves the sale of borrowed stock. Short selling flips the typical investing pattern of buy low, sell high. Instead, short sellers sell high, then buy low with the hope that the stock they borrow (and don't own) will drop in price.
In a simple overview, here’s what it looks like to sell short: You must have a margin account with a brokerage firm, which allows you to use your own securities as collateral. Next, you sell the borrowed security, which leaves you with a negative share balance in a “short position.” You must buy back the security to short the stock. Later, you’ll buy back the stock at — hopefully — the lower price to make a profit on the difference. In the case of rising stock, however, you might have to buy back the security at a higher price and accept a loss.
Because a short position is the opposite of a long position, many features are the reverse of what you might expect. The potential profit (rather than the loss) is limited to the value of the stock, but the potential loss of short selling is unlimited, which is one of the major risks of short selling.
Short sellers can act as a counterbalance to help keep the market healthy by providing liquidity at times when the market needs it.
What are the main risks of short selling?
When you short common stock, you face several different kinds of risk. Let’s walk through the series of risks you should know before you consider selling stock short.
Market risk is one of the biggest risks of short selling. Because there is no limit on how high a stock can go, the market risk you face as a short seller is potentially unlimited. The higher the stock price goes, the more pain you feel.
The risk of corporate actions is just as serious. When a company decides it will pay a dividend , it declares a record date. The record date occurs when the company takes attendance of all the shareholders who can receive the dividend. Once the record date is established, the ex-dividend date (ex-date) is usually set for two business days prior.
When you borrow shares and short them, the lending broker should get the dividends that the issuer pays on the shares that were lent by the broker. As the short seller, you must make payments if you’re short the stock at market close on the day before the ex-date. This reimburses the brokerage for the dividends that it would have received.
The money will be deducted from your trading account and paid to the owner of the shares. Consider how this could be treacherous: If you short thousands of shares with even small dividends, you can rack up big losses.
In the case of more complex events, like a spinoff or issuing warrants, the potential losses can mount even more quickly. Even though you shorted one security to begin with, you could actually become short two securities (or possibly more) at the same time.
Short squeeze risk
Short squeezes can work against short sellers. A short squeeze occurs when many traders short a stock (assume that the stock price will go down) but the stock price goes up instead. One of the most famous short squeezes of all time occurred with GameStop Corporation’s (NYSE: GME) in early 2021, when retail investors surged GameStop’s stock price more than 1,600% in fifteen days.
Stocks that are heavily shorted have buy-in risks, which refers to the closing out of a short position by a broker-dealer because it’s hard to borrow and its lenders want it back.
Regulators may ban short sales in a particular sector and in the market in general. This can cause a sudden spike in stock prices, which forces the short seller to cover short positions and incur huge losses.
Since the stock market rises over time, you’re automatically at a disadvantage as a short seller. When a stock rises, short sellers must cover their trades by buying their short positions back, which potentially puts a lot of money at risk.
When you borrow money through a margin account, this means you use leverage, or borrow stock from a firm in order to sell it and hope that the price will decline. While margin can increase your purchasing power, customers who trade securities on margin may also experience incredible losses.
Does short selling have unlimited risk?
Yes. When you traditionally invest in a stock, you can never lose more than your original investment. However, you could lose unlimited money on a short sale because the value of any asset can climb to infinite amounts.
What are the costs of short selling?
You’ll pay trading commissions, also called stock trading fees, when you buy or sell stocks. You’ll also pay a “hard-to-borrow” fee, an annualized fee based on the value of a short position and the hard-to-borrow rate for that position. This fee varies daily and can be significant. Hard-to-borrow fees have sometimes exceeded a rate of several hundred percent for in-demand stocks.
In addition, you’ll need to meet the margin requirements. The Federal Reserve Board requires all short sale accounts to have 150% of the value of the short sale when the sale is initiated. This includes the full value of the short sale proceeds (100%) and an additional margin requirement of 50% of the short sale value.
When does short selling make sense?
Short selling is not a strategy many investors use, largely because the expectation is that stocks will rise in value over time. In the long run, the stock market tends to go up, although it is occasionally punctuated by bear markets in which stocks tumble significantly.
For the typical investor with a long-term investment horizon, buying stocks is a less risky proposition than short selling. Short selling may only make sense in certain situations, such as in a protracted bear market or if a company is experiencing financial difficulties. That said, only advanced investors who have a high tolerance for risk and understand the risks associated with short selling should attempt it.
What are the benefits of short selling?
Of the short selling benefits, the most obvious is that short selling can give you a profit without putting much money up front. If you make the right decisions about the stock and the stock price plunges, you’ll make money. It has the potential to be incredibly lucrative in certain stock market situations.
As long as you time your trades accurately by entering a trade at the right time, it can result in profits. Of course, this is easier said than done. Timing is also crucial in short selling, so you don’t encounter a decline. Entering too early or too late can cause losses to occur.
Here are a few example situations in which short selling may have the potential to be profitable:
During a bear market
When market fundamentals worsen
When technical indicators predict a bearish trend
When the valuation reaches elevated levels
5 short selling terms you should know
In short selling, it’s important to know specific vocabulary terms before you get started. Take a look at the following terms and invest terms glossary , as well as those below.
Shorting a stock means opening a position by borrowing shares you don’t own and selling them to another investor. Shorting involves selling when you feel confident that the stock will decline.
A short position refers to when a trader sells a security to repurchase or cover it later at a lower price.
A short squeeze occurs when investors and traders have acted on the assumption that an asset would fall, and it instead rises. The stock’s price goes up instead of down in a short squeeze. Because of this, the short seller must decide between covering their position by paying interest on the borrowed shares (hoping that the price will go down) or exit the position by buying shares at a new, higher price and returning them at a loss.
A margin account refers to a brokerage account. However, in this type of brokerage account, the broker lends the customer cash to purchase stocks. The loan in the account becomes collateralized (meaning they are backed by the securities purchased and cash). A margin account also has a periodic interest rate.
A put option is an options term. It’s a contract that gives the option buyer the right — but not the obligation — to sell an underlying security such as a stock at a predetermined price within a specified window of time.
Investors pursuing bearish options can use downward moves in the market to capitalize on an underlying asset. Like short selling, a put option works during a bear market. Unlike short sales, your risk is limited to the premium paid for long put options. Options may expire without worth, however, so there are risks when you use options.
Consider short selling carefully
Short sellers use shorting to express a view that a security is overvalued or to hedge against risk. It offers both risks and rewards.
When you want to get started in short selling, carefully consider whether it’s the right type of trading or investing option for you. Losses can be infinite since there’s no limit to how high a share price can go. It’s important to recognize that the more shares go up, the more potential for loss because you’ll need to return your lent shares, but you may be forced to buy them back at a higher price.
How much you lose depends on how much the shares gained since you borrowed the stock and against the long-term upward trend of the markets. When markets sweep upward, the risks can be even more pronounced.
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