What is Short Selling in Stock Market?

1. To speculate

The most obvious reason to short is to profit from an overpriced stock or market. Probably the most famous example of this was when George Soros “broke the Bank of England” in 1992. He risked $10 billion that the British pound would fall and he was right. The following night, Soros made $1 billion from the trade. His profit eventually reached almost $2 billion.

2. To hedge

For reasons we’ll discuss later, very few sophisticated money managers short as an active investing strategy (unlike Soros). The majority of investors use shorts to hedge. This means they are protecting other long positions with offsetting short positions.

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Why Sell Short?

The most common reasons for engaging in short selling are speculation and hedging. A speculator is making a pure price bet that it will decline in the future. If they are wrong, they will have to buy the shares back higher, at a loss. Because of the additional risks in short selling due to the use of margin, it is usually conducted over a smaller time horizon and is thus more likely to be an activity conducted for speculation.

People may also sell short in order to hedge a long position. For instance, if you own call options (which are long positions) you may want to sell short against that position to lock in profits. Or, if you want to limit downside losses without actually exiting a long stock position you can sell short in a stock that is closely related or highly correlated with it.

Example of Short Selling for a Profit

Imagine a trader who believes that XYZ stock—currently trading at $50—will decline in price in the next three months. They borrow 100 shares and sell them to another investor. The trader is now “short” 100 shares since they sold something that they did not own but had borrowed. The short sale was only made possible by borrowing the shares, which may not always be available if the stock is already heavily shorted by other traders.

A week later, the company whose shares were shorted reports dismal financial results for the quarter, and the stock falls to $40. The trader decides to close the short position and buys 100 shares for $40 on the open market to replace the borrowed shares. The trader’s profit on the short sale, excluding commissions and interest on the margin account, is $1,000: ($50 – $40 = $10 x 100 shares = $1,000).

Example of Short Selling for a Loss

Using the scenario above, let’s now suppose the trader did not close out the short position at $40 but decided to leave it open to capitalize on a further price decline. However, a competitor swoops in to acquire the company with a takeover offer of $65 per share, and the stock soars. If the trader decides to close the short position at $65, the loss on the short sale would be $1,500: ($50 – $65 = negative $15 x 100 shares = $1,500 loss). Here, the trader had to buy back the shares at a significantly higher price to cover their position.

Example of Short Selling as a Hedge

Apart from speculation, short selling has another useful purpose—hedging—often perceived as the lower-risk and more respectable avatar of shorting. The primary objective of hedging is protection, as opposed to the pure profit motivation of speculation. Hedging is undertaken to protect gains or mitigate losses in a portfolio, but since it comes at a significant cost, the vast majority of retail investors do not consider it during normal times.

The costs of hedging are twofold. There’s the actual cost of putting on the hedge, such as the expenses associated with short sales, or the premiums paid for protective options contracts. Also, there’s the opportunity cost of capping the portfolio’s upside if markets continue to move higher. As a simple example, if 50% of a portfolio that has a close correlation with the S&P 500 index (S&P 500) is hedged, and the index moves up 15% over the next 12 months, the portfolio would only record approximately half of that gain or 7.5%.

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Impact of Short Selling on the Stock Market

Short selling is essentially a speculative activity. As such, it has a mixed effect on the market. Depending on the scale and nature of the short, it has the potential to magnify losses, playing havoc with natural price discovery occurring in the markets. Critics of short selling contend that it exacerbates downward price movements, heightens volatility, and causes an exodus of investors from the security being shorted.

During the 1997 Asian financial crisis, investor George Soros was accused by the Malaysian government of “massive currency speculation” because he shorted the Thai Baht and caused the crisis. Short selling was also blamed for the 1929 and 1987 stock market crashes. During the financial crisis, the SEC imposed an emergency ban on short selling in September 2008.

Prominent defenders of short selling include activist investors and firms. For example, Seth Klarman, a hedge fund billionaire who runs Baupost, an investment group, says that short selling is necessary to counter bull markets. Warren Buffett has made the case that short selling helps uncover fraud and false accounting in company balance sheets. Research released by the World Federation of Exchanges claims that short selling bans are harmful to stock markets because they reduce “liquidity, increase price inefficiency and hamper price discovery.”

In recent times, however, the effect of short selling on investment markets has been tamped down due to the rise of passive investing. Pension funds and large institutional investors invest in stocks for the long-term and are averse to short sellers. Vehicles for passive investing, such as exchange-traded funds, guarantee safer bets through fixed returns and fewer losses. They have also taken large holdings in companies to minimize the overall effect of active investors and short sellers in a company’s share price.

What are the Short Selling Metrics?

Traders primarily resort to two short-selling metrics to determine which stocks are overvalued or are expected to fall in value in the future. These are –

• Days to cover ratio

Also known as a short interest to volume ratio, it denotes the relationship between the total numbers of stocks that are held short and its current trading volume in the market. It provides an insight into how well a stock is holding in terms of demand. A high ratio, therefore, indicates a stock a bearish trend.

• Short interest ratio

It represents the relationship between the numbers of stocks that are shorted and the numbers of stocks that are currently afloat in the market. A high ratio would indicate a high short interest and a substantial possibility that such stock will fall in price in the future. On the other hand, a high short interest ratio also exacerbates the possibilities of a short squeeze.

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Additional Considerations with Short Selling

Besides the previously-mentioned risk of losing money on a trade from a stock’s price rising, short selling has additional risks that investors should consider.

Shorting Uses Borrowed Money

Shorting is known as margin trading. When short selling, you open a margin account, which allows you to borrow money from the brokerage firm using your investment as collateral. Just as when you go long on margin, it’s easy for losses to get out of hand because you must meet the minimum maintenance requirement of 25%. If your account slips below this, you’ll be subject to a margin call and forced to put in more cash or liquidate your position.

Wrong Timing

Even though a company is overvalued, it could conceivably take a while for its stock price to decline. In the meantime, you are vulnerable to interest, margin calls, and being called away.

The Short Squeeze

If a stock is actively shorted with a high short float and days to cover ratio, it is also at risk of experiencing a short squeeze. A short squeeze happens when a stock begins to rise, and short-sellers cover their trades by buying their short positions back. This buying can turn into a feedback loop. Demand for the shares attracts more buyers, which pushes the stock higher, causing even more short-sellers to buy back or cover their positions.

Regulatory Risks

Regulators may sometimes impose bans on short sales in a specific sector, or even in the broad market, to avoid panic and unwarranted selling pressure. Such actions can cause a sudden spike in stock prices, forcing the short seller to cover short positions at huge losses.

Going Against the Trend

History has shown that, in general, stocks have an upward drift. Over the long run, most stocks appreciate in price. For that matter, even if a company barely improves over the years, inflation or the rate of price increase in the economy should drive its stock price up somewhat. What this means is that shorting is betting against the overall direction of the market.

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Costs of Short Selling

Unlike buying and holding stocks or investments, short selling involves significant costs, in addition to the usual trading commissions that have to be paid to brokers. Some of the costs include:

Margin Interest 

Margin interest can be a significant expense when trading stocks on margin. Since short sales can only be made via margin accounts, the interest payable on short trades can add up over time, especially if short positions are kept open over an extended period.

Stock Borrowing Costs

Shares that are difficult to borrow—because of high short interest, limited float, or any other reason—have “hard-to-borrow” fees that can be quite substantial. The fee is based on an annualized rate that can range from a small fraction of a percent to more than 100% of the value of the short trade and is pro-rated for the number of days that the short trade is open.

As the hard-to-borrow rate can fluctuate substantially from day to day and even on an intra-day basis, the exact dollar amount of the fee may not be known in advance. The fee is usually assessed by the broker-dealer to the client’s account either at month-end or upon closing of the short trade, and if it is quite large, can make a big dent in the profitability of a short trade or exacerbate losses on it.

Dividends and other Payments

The short seller is responsible for making dividend payments on the shorted stock to the entity from whom the stock has been borrowed. The short seller is also on the hook for making payments on account of other events associated with the shorted stock, such as share splits, spin-offs, and bonus share issues, all of which are unpredictable events.

Advantages

• Provides liquidity to the market, which may reduce stock prices, improve bid-ask spreads and assist in price discovery.
• Ability to hedge an existing portfolio’s long-only exposure and reduce the overall market exposure.
• Short Selling helps the manager use capital proceeds to overweight the portfolio’s long-only component.
• Exposure to both short and long positions can minimize a portfolio’s overall volatility and the ability to add meaningful risk-adjusted returns.

Disadvantages

• Shorting stocks is considered highly volatile, while t’s possible for a stock to fluctuate and go to zero, but this will be seen in a rare case. Stock prices tend to revert, and this turnaround can be quick and significant on the back of some events.
• Borrowing stock can be difficult if the amount of available stock in the market is limited or less liquid names.
• Less liquid stocks can be expensive to buy, and the exchange may limit or ban short Selling during volatile market conditions.
• Short sellers run the risk of borrowed stock recalled by their broker when the short seller has limited control over the price of covering their position.
• While the maximum potential for shorting a stock is 1x, a stock price should be appreciated as there is no limit to the potential losses.
• Short squeezes, where rapid and high upward price fluctuates cause short sellers to cover in mass, can push prices against short-sellers.

The Risks

Now that we’ve introduced short selling, let’s make one thing clear: shorting is risky. Actually, we’ll rephrase that. Shorting is very, very risky… not unlike running with the bulls in Spain. You can have a great time, or you can get trampled.

You can think of the outcome of a short sale as basically the opposite of a regular buy transaction, but the mechanics behind a short result in some unique risks.

1. History has shown that, in general, stocks have an upward drift. Over the long run, most stocks appreciate in price. For that matter, even if a company barely improves over the years, inflation should drive its stock price up somewhat. What this means is that shorting is betting against the overall direction of the market.

2. When you short sell, your losses can be infinite. A short sale loses when the stock price rises, and a stock is (theoretically, at least) not limited on how high it can go. On the other hand, a stock can’t go below 0, so your upside is limited. Bottom line: you can lose more than you initially invest, but the best you can earn is a 100% gain if a company goes out of business.

3. Shorting stocks involves using borrowed money, otherwise known as margin trading. Just as when you go long on margin, it’s easy for losses to get out of hand because you must meet the minimum margin requirement. If your account slips below this, you’ll be subject to a margin call –you’ll be forced to put in more cash or liquidate your position. (As mentioned earlier, we won’t cover margin details here because we have an entire tutorial devoted to it.)

4. If a stock starts to rise and a large number of short sellers try to cover their positions at the same time, it can quickly drive up the price even further. This phenomenon is known as a “short squeeze.” Usually, news in the market will trigger a short squeeze, but sometimes traders who notice a large number of shorts in a stock will attempt to induce one. This is why it’s not a good idea to short a stock with high short interest. A short squeeze is a great way to lose a lot of money extremely fast.

5. The final and largest complication is being right too soon. Even though a company is overvalued, it could conceivably take a while to come back down. In the meantime, you are vulnerable to dividends (which you would have to pay), margin calls, and being called away. Academics and traders alike have tried for years to come up with explanations as to why a stock’s market price varies from its intrinsic value. They have yet to come up with a model that works all the time, and probably never will.

Take the dot-com bubble, for example. Sure, you could have made a killing if you shorted at the market top in the beginning of 2000. But many believed that stocks were grossly overvalued even a year earlier. You’d be in the poorhouse now if you shorted the Nasdaq in 1999! This is contrary to the popular belief that pre-1999 valuations more accurately reflected the Nasdaq. However, it wasn’t until three years later, in 2002, that the Nasdaq returned to 1999 levels.

Momentum is a funny thing. Whether in physics or the stock market, it’s something you don’t want to stand in front of. All it takes is one big shorting mistake to kill you. Just as you wouldn’t jump in front of a pack of stampeding bulls, don’t fight against the trend of a hot stock.

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