Financial Jargon Busting What is short selling?

How short selling works

If you’ve ever watched “The Big Short” or “Billions,” you might have heard of the term short selling. But what exactly does it mean, and how does it work?

Short selling, or “shorting,” is the act of selling a financial instrument, such as a stock, with the intention of buying it back later at a lower price to profit from the price difference. It is the opposite of the traditional buy first and sell later process. But, the basic premise of profitable investing – buy low, sell high – is still relevant.

In the context of the stock market, short selling involves borrowing the stock you plan to sell, usually from the brokerage where your account is held, before selling the stock. Unlike the traditional buy-and-hold type of investing, this strategy depends on buying back the shares at a lower price, which is where you generate a profit. You also have to return the shares to the brokerage (lender).

Why short a stock?

The main reason to short a stock is to profit from its anticipated decline. As the seller, you would have reason to believe that the stock in question is trading at an inflated level and that the market will eventually send its price to a more reasonable, lower level. Clearly, this is subjective, as the market might not share your conviction, in which case you run the risk of losing money.

Proponents of market efficiency believe that short sellers provide a useful service to the market. When short sellers put the stock they borrowed up for sale, those shares become available to buyers, adding to liquidity. Short sellers are also essential to increasing the efficiency of the market. When short sellers identify an overvalued stock, the price tends to decrease as the markets adjust to the negative information, resulting in more realistic prices.

Short selling risks

Short selling is a risky move. If the price of the shares you’ve shorted goes up instead of down, you can quickly find yourself on the hook for big losses. Consider that, if you go long on a stock, the worst that can happen is the price goes down to zero, wiping out your initial investment. But since the price of a stock you’ve shorted can theoretically keep rising, there is no limit to how much you can lose.

To borrow shares from your broker and initiate a short sale, you will need a margin account. Trading on margin comes with its own risks. For one thing, you might be subject to a margin call – when your broker requires you to add money to keep the account at a minimum level. Also, it’s important to keep in mind that brokers charge interest on stock loans, which can reduce any potential profit.

Another risk to short sellers is being vulnerable to a short squeeze. This refers to a sudden rush by short sellers to exit their positions en masse. The catalyst is usually some event that results in short sellers questioning their conviction, which leads them to “cover” their shorts (this is what happened during the meme stock frenzy). This act of buying the stock back feeds on itself, intensifying the buying pressure and further pushing the price of the stock up. This, in turn, could result in losses for short sellers because the stock price might be higher than the price at which they originally sold it.

Typically, the volatility that ensues with the surge in prices during a short squeeze does not last long because there is no fundamental basis to support the sharply higher market valuation, but by then, the damage to the short seller’s account has been done.

Short selling process

If you're considering short selling, here’s a quick overview to help you understand the process.

1. Get approved: Before you can start short selling, your brokerage will likely need to approve your account. This typically involves meeting eligibility criteria and signing risk disclosures to acknowledge the risks involved. Be sure to verify the details with your brokerage.
2. Set up a margin account: Since short selling involves borrowing shares, you'll need a margin account. These accounts often have specific requirements, like a minimum balance and margin maintenance. Be aware of the risks, including potential margin calls and interest on borrowed shares.
   
3. Choose your stock: Decide which stock you want to short. Thoroughly research the stock to identify potential targets. Not all stocks can be shorted, so check with your brokerage.
   
4. Place your short sale order: Once your margin account is set up and funded, instruct your brokerage to short the stock you selected. The brokerage will find the shares for you to borrow and handle the sale on the market.
   
5. Close your position: When you're ready to complete the trade, you'll buy back the shares and return them to your brokerage. Your account will be adjusted based on the stock's price change. If the stock price rises, you could incur significant losses.
   

Which stocks to short?

Identifying a stock that is ripe to be shorted involves understanding the industry and market a potential target company is in. Basically, potential short sellers should thoroughly research the stock and vet any piece of information that could influence the outcome of their trade.

That said, most short sellers use either technical or fundamental analysis – or a combination of the two – to pinpoint their targets. Technical analysis tries to predict the direction of prices by studying past market data like price and volume. Fundamental analysis looks at a company’s financial health and might consider a negative earnings surprise or any other event, like a lawsuit, that can portend a decline in the price of the stock.

Short interest ratio

Short interest ratio is an indicator that approximates the time it might take for all the shorts to cover their positions. It is calculated by dividing the number of shares shorted in a company by that stock’s average daily trading volume. The higher the ratio, the more difficult it might be for short sellers to cover their position. There isn’t one standardized number that can be used as a marker, but most short sellers use a short interest ratio range of eight to 10 to warn them of the rising risk of a short squeeze.