Shorting a Stock
Shorting a stock, or short selling, means to sell a stock which you do not actually have ownership of so you may profit from its potential decline in price. The shares of the stock are borrowed by your broker and then sold in the open market. The resulting funds are deposited in your account. The hope is that you can by them back later at a lower price in order to return them to their rightful owner. When successful, this will allow you to pocket the difference in price as a profit. In order to do this, you must have a margin account with your broker and your broker must have the shares available to loan to you. The number of shares you can borrow is based on the cash already in your account.
At first glance, the act of shorting a stock does not appear to be much more complex than simply the reverse of buying a stock. However, before you run out and start shorting stocks, let’s look at what else is involved and why shorting stocks is generally considered more risky than going long. You should also keep in mind that shorting stocks involves potentially unlimited risk. This is because stocks can go higher with no limit and if you are short the shares, you are on the hook. By contrast, when going long, a stock can “only” go to zero.
As you will see by reading this text, there are a number of differences between shorting stocks and buying stocks that you should be very aware of. Interestingly, each of these differences, when taken separately, does not seem all that important. However, when combined together, they can and do increase the risks associated with shorting a stock; this is especially true should things turn against you in the market.
Let’s continue by examining some of the more important factors to keep in mind when considering short selling:
WHERE DO YOU BORROW STOCK FROM – One of the first questions that comes to mind when talking about shorting stocks (i.e. selling borrowed stock to reap a profit by buying it back at a lower price) is where does the initial stock actually come from? This is a good question and one that often times comes into play when attempting to short a stock in the first place.
The fact is, you have to be able to borrow the shares to begin with to short a stock; sometimes this is actually not always possible. When you place an order to short a specific stock, a search is made to find available shares in the market. Interestingly enough, shares are borrowed from other investors’ accounts without the knowledge of the original stock holder. Firms usually search their own accounts first, then the accounts of larger firms in an effort to find shares to short. The larger the firm you deal with, the more luck you may have shorting the stock you want.
Shorting shares of IBM, MMM or GE may not be much of a feat, since stock is generally readily available in many accounts across the country for these types of larger companies. When a stock is widely held and quite liquid, more than likely shares are available at the brokerage firm where you are placing your order. However, should you suddenly try to short shares in a stock which is more thinly traded or which is not as widely held, you may run into more difficulty. In fact, often times you simply cannot short certain stocks because no shares can be found to borrow (note: sometimes providing your brokerage firm with 24 hours notice on the stock(s) you wish to short can help matters).
However, assuming there are shares available, your firm will borrow the shares and allow you to sell them in the open market. The resulting sale will leave you “short the stock” and you will have the profits from the sale deposited into your account just as with any other sale of stock.
As mentioned, you must have funds in your account in the first place in order to short stocks – just as you would in order to purchase a stock. In other words, you cannot wake up tomorrow morning and suddenly short 5 million shares of stock in CSCO without having an equal amount of money to back up the sale.
THE CATCH – The main stipulation here when shorting a stock is that should those original shares suddenly be called upon by the original owner (for example, to be sold), they must immediately be returned and/or covered by the firm loaning out the shares (and that means you really). If replacement shares are not available, or a shortage in the shares occurs, you may be faced with having the stock “called away” from you. When this happens, the only recourse you may have is to buy the stock [immediately] in the open market – regardless of price. As you may be starting to see, shorting has aspects not normally associated with buying stocks.
OTHER STOCKS YOU CANNOT SHORT – Aside from being unable to locate shares to short in the first place, there are other cases in which you may find that you cannot short a stock. Generally speaking, you cannot short most IPO’s, nor can you short stocks under $5 (however, as an interesting side note, I believe in Canada you can short stocks of any price). Typically, it’s best to call ahead and make sure there are shares available to short in the stock you are interested in and that it meets all shorting guidelines for the brokerage firm you are using.
THE UPTICK RULE FOR SELLING – Assuming you find shares to short, there are certain rules which control the sale of the stock depending on which exchange it trades upon. Generally speaking, you cannot sell a stock into a falling market. This is where the “uptick” rule comes into play.
As you can probably imagine, this is done to help keep short sellers from causing a sliding market where nothing but selling is taking place. Normal selling is viewed one way in the market, while short selling is viewed somewhat differently.
Should you attempt to sell borrowed stock, you may find that you have to wait for what is called an “uptick” in some cases. On the NYSE exchange, this means that a short sale may only be done on an uptick or a zero plus tick – a price that is the same price as the last trade, but higher in price than the previous different trade. On the Nasdaq exchange, you cannot short on the bid side of the market when the current inside bid is lower than the previous inside bid (a down tick). If you are shorting stocks on other exchanges, you’ll need to review the rules associated with that exchange or ask your broker to explain what is required for each individual situation. But, in general, you can only short into a rising or stable market. Once the market does up tick, you can then sell your stock at the current bid price offered in the market. The profit resulting from the sale is then deposited into your account.
ADDITIONAL UPSIDE RISKS TO SHORTING – One of the first differences you should note when shorting stocks is the large additional upside risks which are involved. When you buy a stock, the worst that can happen is the stock will go to zero. However, when you short a stock, it can go up forever. This is a very important point to consider before shorting any stock, since the upside risks are basically unlimited (although there are margin requirements that will eventually kick in and result in a margin call).
THE BENEFITS OF SHORTING – Interestingly, there is a benefits to shorting stocks. Typically, and this is only a guideline, stocks tends to fall about twice as fast as they climb. As you know, negative news can bring down a stock very quickly – sometimes wiping out months’ worth of gains in a single day or two. From this standpoint, if you do hit a short play correctly, your gains can sometimes be realized in a shorter time period than waiting for a stock to gain ground and move higher.
THE LATENT DEMAND THAT SHORTING CREATES – Another aspect of shorting stocks that you should always keep in mind, and which in some respects increases risk, is the idea of “latent demand”. When you short the stock, you actually are building up latent demand for the shares. This is because at some point in the future (unless the company goes out of business) you will have to be a buyer of the stock in order to return the shares to their rightful owner. A wave of short sellers will one day mean a wave of buying.
SHORT SQUEEZE – If you have been trading stocks for any amount of time, you will have probably heard the term “short squeeze”. A short squeeze is actually when there is a sudden demand (i.e. buying) in a stock which has a large amount of shares outstanding on the short side. If the buying keeps up and starts to force short players to cover their short positions, the result can be quite sever. Buying increases the share price, which in turn tends to produce additional fear (and short covering) among short-side players in the stock market. As people rush to buy stock and cover their positions, this continue to dizzying heights until a normal supply/demand situation returns to the market. As the old saying goes, “He who sells what isn’t his, buys it back or goes to Prison”. The bottom line is that if the stock you have borrowed and sold is suddenly required, you may end up being “bought in” whether you like it or not.
SHORT COVERING – Assuming everything goes as planned, then at some point you will cover your short position to complete the trade. In order to complete a short sale, you will need to repurchase and return the borrowed shares of the stock. This is called “covering” your short position and completes the transaction.
Incidentally, when placing your order, you should specifically instruct your broker that you are covering an open short position, otherwise it’s possible to end up with both a long and short position in play. Ideally, you’ll be covering your short play at a lower price than where you sold the shares and this resulting difference in price will be your profit.
ONE ADDITIONAL CAVEAT – If you are short a stock at the same time as a stock dividend is paid, don’t forget that you owe that dividend to the owner of the original stock. Your broker will charge your account for the amount of the dividend owed based on the number of shares you have borrowed. Keep this in mind when shorting dividend-paying stocks.