Put simply, short selling is when an investor borrows securities and sells them hoping to repurchase them at a lower price in the future, thus making a profit. This is what short selling is in a nutshell. However, one must not oversimplify this investment strategy, as short selling not only comes with opportunities for significant profits – it also implies grave risks. Combined with several cons you might want to know about, short selling is an activity not to be taken lightly.
This article will introduce you to short selling, giving you the pros and cons, why you might want to try it, and, most importantly, what you must be aware of.
How does short selling work?
When you short sell, you try to speculate on the anticipated stock price decline. Short selling is something only experienced market actors should do. To open a position for short selling, one must first borrow shares or some other asset that one expects to drop in value. After that, one sells the borrowed shares to those willing to pay the market price.
The next step is to wait for the shares to get cheaper so the investor can buy them back at a lower price and return them to the lender. The main trick here is that the price may not fall but rise instead. Thus, the potential risk is virtually unlimited.
What are the risks of short selling?
The opposite of the short position is the long position. When you go long – trade the shares you own – in case of failure, you only lose the money you invested. So if you buy one share at $100, the maximum you can lose is $100. That’s because the stock cannot possibly go down below $0. Short selling is when the story takes a dramatic turn. When you short sell, in theory, there is no limit to how much you can lose if you fail, as a stock’s price can potentially hit through the roof.
Let’s get back to the recent example: with a $100 share, if the price goes up to $300 before you exit, your loss will be $200 per share.
Another risk a short seller can face is a short squeeze. It’s a situation when a stock that has been heavily sold short grows in price dramatically. The process makes more and more short sellers repurchase the stock to close their deals as the price rise gets extreme and investors try to limit their losses. In light of what’s been said, it only makes sense to short sell if you are an experienced investor ready to face serious financial risks. If it’s not your story, you might want to try something less risky.
A lower-risk alternative to short selling
Buying a put option on the same stock is an alternative to short selling that limits your downside exposure. When you own a put option, you can sell the stock at a specified price, called the strike price. If the stock’s price goes up, your loss will be limited to what you had paid for the put option (the option premium). The option premium size depends on the strike price and the put option expiration date. The higher the strike price and the farther the expiration date, the higher the option premium.
Here’s an example: a stock trades at $100 on April 10, 2023. A put option costing $15 per share has a strike price of $100, which expires in two weeks on April 24, 2023. So if the stock’s price goes above $100, your loss will be limited to $15 a share (plus commissions).
How can short selling make money?
Look at it as the reverse side of the risks that short selling implies. When you put shares on sale expecting their price to fall and your expectation proves correct, you repurchase the shares at a lower price, making for a difference between the selling price and the buy price. The said difference in prices is your profit. The bigger the difference, the better for the trader.
Here’s a simple example of a short sale: say, there’s a stock that trades at $50 a share. You borrow 100 shares of the stock and sell them for $5,000. Then the price behaves how you expected it to – it comes down.
To make calculations simple, let’s say the price drops to $25 a share. When that happens, you purchase 100 shares to replace those you borrowed. Your profit, in this case, is $2,500. However, there is something else you should know about short selling – the costs involved.
Does going short imply expenses?
The answer is yes. When you plan to go short, you must consider the following costs:
- Margin interest. There is no way you can start short selling without a margin account. Thus, each short seller has to pay interest on the borrowed funds.
- Stock borrowing costs. Chances are you won’t be able to borrow shares of some companies because of high short interest or limited share float. Borrowing such shares will require a hard-to-borrow fee. This type of fee is based on an annualized rate; it can be pretty high and is prorated for the number of trades that the short trade is open.
- Dividends and other payments. Finally, each short seller may need to make dividend payments on the shorted stock plus payments for other corporate events associated with the stock they short sell, including stock splits and spinoffs.
Pros and Cons of Short Selling
Market actors turn to short selling for the following reasons:
- Selling short gives an opportunity to win big.
- This strategy requires relatively small initial capital.
- Going short is possible with leveraged investments.
- Investors can hedge against other holdings.
On the other hand, short selling has some serious drawbacks:
- If you fail at short selling, your losses can be potentially unlimited.
- You can’t go short without a margin account.
- Short selling includes paying a margin interest.
- Short squeezes can drive you deeply into debt.
Conclusion
Investors and traders contemplate short selling as a way to profit in a down market by borrowing shares, selling them at a market price, and then repurchasing them at a lower price in the future. That is, of course, if a bearish forecast comes true. Some criticise the concept of short selling as betting against the market, but on the other hand, many tend to consider short selling as a stabilising force that makes markets more efficient.
Short selling can indeed bring significant profits. However, it comes with serious risks associated with virtually unlimited financial losses in case of failure. Another thing to consider is related expenses such as margin interest and stock borrowing costs that add to the overall complexity of short selling.
This is for informational purposes only and does not contain — or to be considered as containing — investment advice, suggestion or recommendation for trading.
