This post will examine short selling or short positions in stocks, what it means, the uses of this particular trading strategy as well as the risks involved.
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Short selling explained
Definition
Typically, short-sellers borrow the assets from their broker, who may lend from their own inventory, another broker’s inventory, or from customers who have margin accounts and are willing to lend their shares.
You must have a specific brokerage account that allows you to start shorting. You’ll also need to meet your broker’s initial and maintenance margin requirements. For example, suppose that your broker has a 50% initial margin requirement on shorted stocks.
In this case, you’d need to have at least $5,000 in your account to open a $10,000 short position. Additionally, the short seller is responsible for making dividend payments on the shorted stock in its entirety to whom the stock has been borrowed.
Generally, short selling is a bearish investment method that involves the sale of an asset that is not held by the seller but has been borrowed and then sold in the market. A trader will embark on a short sell if they foresee a stock, commodity, currency, or other financial instruments significantly moving downward in the future.
Watch the video: How Short Selling Works?
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Uses of shorting
Usually, you would short the stock because you believe a stock’s price will fall. In essence, if you sell the stock today, you’ll be able to repurchase it at a lower price later.
If this strategy works, the short-seller can repurchase the stock at a lower price, return it to the original owner, and pocket the difference between the selling and buying price for a tidy profit. However, if the price goes up, the trader may be forced to close the position at a loss.
Since the long-term trend of the market has traditionally moved upwards, the strategy of short selling is seen as being risky.
On the other hand, there are market conditions that seasoned traders can take advantage of and turn into a profit. For example, institutional investors will often use shorting as a hedging strategy to reduce the risk for the long positions held in their portfolios. Others use short selling purely for speculation.
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Selling short example (hedging strategy)
Let’s assume you are an investor in X stock. You own 300 shares at an average price of $50 per share. You are reluctant to sell, but you’re also worried about the company’s short-term prospects due to an adverse news event, a disappointing earnings report, or a looming bear market.
In this case, you decide to short 300 shares of X at $50. Indeed, your long position starts losing money once the stock’s value drops below $50. However, the profits from your short sale can negate those losses.
For example, let’s imagine that X drops to $45 per share before beginning to rebound. Then, at $48 per share, you decide that X is on the upturn and exit the short position to secure profits and avoid eroding the eventual gains of your long position (in which you benefit from X appreciation).
Selling short (speculation)
Let’s inspect what a short sale of X stock might go. At present, the stock is being sold for $100 per share. But, you anticipate the stock’s price to fall and short 100 shares for a total sale price of $10,000.
Suppose your forecast was correct, and the share price for X drops to $70. You then proceeded to buy 100 shares to replace the ones you borrowed for $7,000. Excluding interest and any dividends that must be paid out, your profit would be $3,000 ($10,000 – $7,000 = $3,000).
Conversely, let’s assume that your guess was wrong and the price of X booms to $130 per share before you finally opt to close your position. At $130 per share, you’d have to pay $13,000 to replace the 100 borrowed shares, resulting in a $3,000 loss ($10,000 – $13,000 = -$3,000).
Short selling vs. long put options
Short selling is somewhat similar in strategy to a long put options. Long put options grant the buyer the right to sell shares of stock at a preset price in the future, essentially, too, betting a stock’s share price will decline.
The critical difference is that, with a long put, you don’t have to borrow outright to buy the stock upfront and hope it decreases in value before you have to reimburse it. Instead, you merely reserve the right to do so before the end of the options contract. Then, if the drop doesn’t happen, you just let the option expire.
Special considerations
Potentially limitless losses
The primary risk of short selling is that your prediction could be wrong, and the stock price may increase instead. And the gamble of an incorrect guess is much higher with short selling than with traditional investing.
In traditional investing, your upside is unlimited when you buy a stock, while the limit to your loss is all of your investment or 100% (if the stock price falls to $0). But, with short selling, the exact contrary applies. Your maximum profit is 100% (if the stock drops to $0), while your loss potential is technically unlimited.
For instance, assume you short a stock at $25 per share. If the price were to drop to $0, your profit would be as high as it could go at $25 profit per share. But if the trade goes against your forecast, the stock could grow to $50 (100% loss), $75 (200% loss), $100 (300% loss), or even higher, making your losses potentially infinite.
Margin calls
If the stock you sell short rises in price, the brokerage firm can implement a margin call, which requires additional capital to maintain the required minimum investment. If you can’t provide extra money, the broker can close out the position, and you will incur a loss.
On the other hand, this can function as a stop-loss provision. As potential losses on a short sale are unlimited, a margin call effectively limits how much loss your position can sustain. The major negative of margin loans is that they enable you to leverage an investment position. While this can bring the opportunity for extraordinary profits, it also multiplies your losses on the downside.
Brokerage firms commonly allow you to margin up to 50% of the value of an investment position. A margin call will usually apply if your equity in the position plunges below a certain percentage, typically 25%.
What is a short squeeze?
A short squeeze occurs when a stock begins to sharply and abruptly rise, and short-sellers cover their trades by repurchasing their short positions. This buying can become a vicious circle: demand for the shares attracts more buyers, which drives the stock higher, causing even more short-sellers to cover their positions. Short squeezes typically happen when a high percentage of all the stock’s outstanding shares are sold short.
Gamestop short squeeze
GameStop (NYSE: GME) is a video and computer game retailer had been shorted by Melvin Capital hedge fund since 2014. The stock was at $40 a share, and several Wall Street analysts had released research reports declaring the stock was worth even less.
But rather than fall in price, GameStop shares surged in January 2021, at one point reaching $350. In short, GameStop had caught the fancy of retail traders who had clubbed together on Reddit and other platforms to drive the stock up.
By inflating the price of GameStop shares, the day traders tangled the short-sellers in a short squeeze, where they couldn’t get out because the stock just kept going up. So while GameStop stock surged, hedge fund Melvin Capital Management lost 53%.
Pros and cons of short selling
Pros
- The possibility of profiting on short-term declines in a stock’s value;
- Potentially significant gains without putting too much capital upfront;
- Hedge against a long position, i.e. shares you already hold in your portfolio;
- Leveraged investments;
- One of the few ways to make money in a bear market.
Cons
- Potentially unlimited losses: leverage trading can be dangerous because it can massively amplify your potential losses, in some cases losing more than you had to invest in the first place;
- Upward market trend: over the long run, most stocks appreciate, meaning the overall trend is against you as a short-seller;
- A short squeeze: when a stock’s value skyrockets and short-sellers franticly scramble en masse to buy back shares to cover their position;
- Margin account necessary: if your account slips below the minimum maintenance requirement, you’ll be subject to a margin call and asked to put in more cash lest they liquidate your position;
- Margin interest: you have to pay interest on the borrowed stocks until they’re returned;
- Wrong timing: even though your hunch about a company being overvalued can be correct, it can take some time for its stock price to fall, and in the meantime, you will be vulnerable to interest and margin calls.
In conclusion
To sum up, short positions are bearish strategies since the stock is required to fall for the investor to profit. In addition, shorting is a high-risk, short-term trading method and demands close monitoring of your shares and meticulous market-timing.
As a result, it may not be suitable for beginner investors who prefer taking a passive investment approach with their portfolios.
Conversely, for active traders, short selling is a method that can deliver positive returns even in a looming bear market or a period of meager returns. But if you decide to short stocks, it is crucial to understand the risks fully and have a detailed exit procedure for getting out of the position fast if the stock price rises against you.
Disclaimer: The content on this site should not be considered investment advice. Investing is speculative. When investing, your capital is at risk.
FAQs about the short position
What is short selling?
Short selling is an advanced high-risk speculative trading strategy that benefits from a stock price’s fall. It means selling an asset you don’t hold in your portfolio that you predict to drop in value later. Instead of purchasing the stock outright, you borrow it, sell it, and put the money aside. Then, after the price has dropped, you repurchase the stock and return it to the lender, keeping the difference as profit.
What are the risks involved with shorting?
Selling short will only make money if the stock price falls. If your hunch is wrong and the price rises, you are out the difference. However, the real risk is that your loss is potentially infinite. If the price skyrockets, you have to buy it at whatever elevated price to return the stock to your lender. There is essentially no limit to your loss.
What is a short squeeze?
A short squeeze is when a stock’s value skyrockets, causing many short-sellers to franticly try to close their positions and buy back the stock, driving the price up even faster.
What is the opposite of a short position?
The opposite of a short position in stocks is a long position, which is opening a position with a buy order instead of a sell order. In short, the opposite of shorting a stock is buying it.
What is a synthetic short position?
A synthetic short position is a trading strategy that simulates short selling a stock without actually borrowing the shares. It’s typically created by buying a put option and selling a call option on the same stock, with the same strike price and expiration date. This setup aims to mirror the returns of a traditional short sale, profiting when the stock’s price decreases.
How to cover a short position?
To cover a short position, an investor needs to buy back the same number of shares they initially sold short and return them to the lender. This is typically done when the investor believes the stock price has reached its lowest point or to cut losses if the price is rising. By buying the shares at a lower price (ideally) than the selling price, the investor closes the position, completing the short-selling transaction.
What is a short put position?
A short put position occurs when an investor sells (or “writes”) a put option. This strategy involves the investor receiving the option premium upfront, betting that the underlying asset’s price will stay the same or increase. If the asset’s price stays above the put option’s strike price at expiration, the option expires worthless, and the investor keeps the premium as profit. However, if the asset’s price falls below the strike price, the investor may be obligated to buy the asset at the higher strike price, potentially incurring a loss.
What is a short call position?
A short call position is when an investor sells a call option, receiving the premium upfront and betting that the underlying asset’s price will not rise above the strike price. If the asset’s price stays below the strike price at expiration, the option expires worthless, and the investor keeps the premium as profit. However, if the asset’s price exceeds the strike price, the investor may face losses.
What was the timeline of the GameStop short squeeze?
The GameStop short squeeze occurred primarily in January 2021. It started with retail investors from online platforms like Reddit’s r/wallstreetbets buying GameStop (GME) stock, recognizing that it was heavily shorted by hedge funds. This buying frenzy drove up the stock’s price, triggering a short squeeze where short sellers had to purchase shares to cover their positions, further escalating the price. The peak of the squeeze happened towards the end of January, resulting in significant media attention and discussions about market dynamics and retail investor influence.
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