Short selling stocks is a trading technique which is designed to profit from a subsequent drop in the price of the shares which have been ‘short sold’. The term refers to the selling of shares which have actually been borrowed (usually from a broker) rather than purchased by the seller. This is done when the short seller expects the share price to drop, in which case they can later buy the shares at a lower price to return to the broker, thereby generating a profit.
In a sense, short selling is akin to using put options in the options market, since in both these cases, the trade will make money in the event that the share price falls, and as such, both these types of trading may be described as ‘bearish’.
How to Profit from Short Selling
The profit from short selling is attained if the trader is able to purchase the shares for a lower price than they sold them for. For example if shares were short sold for $18, and then the seller is later able to buy them for $15 and return them to the broker, an increase of $3 per share (minus costs) has been achieved. The return to the broker of the borrowed shares is known as covering the short.
How to Short Sell Stocks
Short selling stocks generally requires the use of a margin account, which means that the trader is approved by the broker to borrow a certain percentage of the capital required for trading. A margin account must be set up with a minimum cash deposit which has been set by U.S. federal requirements as being $2000.
When a stock is short sold, the proceeds of the sale are deposited into the trader’s margin account. The total amount received for the sale must be kept in the margin account for the length of time that the short is open. Because the trader does not actually own the shares that they have sold, the money may not be accessed before the short has been covered. In addition to holding the entire amount of money received from the sale, an additional 50% of the initial value of the shares must also be maintained in the margin account. This extra 50% is intended to help cover the loss that may be incurred if the price moves unfavorably for the short seller.
Once the margin account is established, and the necessary capital is available, an order to short sell can be placed with the broker. The broker will locate shares available for loan from their own customers, or various other sources such as fund management companies or clearing firms. The shares are then sold, and the proceeds of the sale are credited to the short seller’s margin account.
The intention of short selling stocks is to buy the shares at a lower price than the price they were sold for, and to profit from the difference between the two prices. The seller may typically keep a short position open for as long as they wish, and, assuming that the price is moving in favor of the seller, they wait for an opportune moment to buy the shares and cover the short. This moment is a point at which they believe the price is unlikely to keep dropping and will begin to rise again.
Risks of Short Selling
In the event that the price moves unfavorably by rising, at some point the short seller will have to cover the short by purchasing the shares at a higher price than they received for the initially borrowed shares. They may want to keep the position open longer, hoping that what is going up will come back down again, but this is not always possible, as the broker may decide that it is time for the trader to cut their losses, and cover their position. The broker demanding the covering of a short position is known as a ‘buy-in’ and is often instigated because the owner of the shares wants to receive the profit attained by the increased price.
Another potentially unwelcome situation for a short seller is that they may be issued with a margin call, which requires them to deposit additional funds into their margin account to cover the greater liability that the increasing stock price is creating. If they are unable to cover this margin call, the broker may insist that the position is closed.
Assuming that the seller is able to cover any margin calls, and is not faced with a buy-in, they could decide to keep their losing position open longer in the hope that it will eventually turn in their favor. Doing so has the possibility of resulting in enormous, basically unlimited, losses as there is virtually no limit to how much a stock price can rise.
It is also important to bear in mind that short selling stocks offers limited potential gain, as there is certainly a limit to how low a price can drop.
While short selling stocks is a viable way of making a profit from a decrease in stock prices, it is also a form of trading which carries many requirements, a high level of risk, and a limited amount of potential gain.