Most people when they hear about the stock market think of the old cliche "buy low, sell high" meaning that in order to make money in the stock market one should try to buy a stock at a certain price, then hold for some time and sell later for a higher price. Although that is a good way to net profits in the stock market, that is far from the only way to do so. If you do your research and find a stock that you think will go higher, then what you do is buy it, hold until it appreciates and then sell it at a higher price, pocketing the difference between the buying and selling price. Well what if based on your research (fundamentally or technically based) you have reasonable grounds to believe that a stock will go down? Is there a way to profit when a stock price goes down?
The answer, of course, is yes and that is exactly what short selling is all about: profiting when a financial instrument (in this case stocks, but it could be any instrument) decreases in price. Conceptually, in any financial instrument you are said "to be long" if an increase in its market price would make you a profit and you are said "to be short" that instrument if a decrease in its price would make you a profit.
When talking about stocks, if you believe it will go up you buy it and then later when it's higher you sell it for a profit. If you think it will go down, then you sell it short and then later when it's lower you buy it back for a profit. Remember here that when talking about short selling I am not talking about buying a stock that you already have before it declines (if you own a stock that you think will go down you should definitely sell it but that is not short selling, that is simply selling) but rather to sell a stock that you don't have.
Conceptually, for most people the concept of short selling is a little bit hard to understand. After all, in real life you have money and then you buy things with that money and, if they are for investment purposes, you wait and then when it has appreciated you sell what you bought before. Short selling is different and your mindset needs to be adjusted when looking at financial markets. I think this is one of the most important concepts for you to grasp and the first one that will differentiate you from most amateur investors or traders. If you are a "long only" investor or trader, your fortunes are for the most part tied to the fortunes of the stock market and how the economy is doing. If you are a professional investor or trader and have a mindset that incorporates both going long and going short, your fortunes are not going to depend on how well the economy or the stock market is performing but rather simply on your investing and/or trading skills.
We won't go into the mechanics of short selling in this article since it is important that you have a solid understanding of what short selling is before you learn how to do it. It is however important that you understand how to use short selling with a simple example so that you can see that in essence, short selling is the mirror image of what you do when you buy a stock.
Let's say you are looking at a stock such as for example Bank of America (ticker: BAC) trading currently at $16.44 per share. After you have done some research, you believe that the stock could go lower from this price point so you decide to sell it short. Let's say you short 1000 shares at $16.40. Now, you have a short position open meaning that you have initiated your short position but still need to close it, which you do by buying back the shares that you sold or "buying to cover your short". Let's say that the stock goes to $15, at that point you would buy to cover your short position and because you shorted 1000 shares from $16.40 you would have a net profit of $1,400 (minus commisions). You have made money even though the stock you are investing in or trading went down.
Now let's take a look at what happened behind the scenes in the example that we saw above. When you initiate a short position, what you are actually doing is selling a stock that you don't have so how can this be done? The answer is that you borrow the shares from someone else who already has those shares, you sell those shares in the market and the proceeds go to your account (remember, you didn't have those shares to begin with and now you have the money that you pocketed from selling those shares in the open market). At this point you have the proceeds from the sale in your account but you now owe (or are "short") those shares to the person you borrowed those shares from. When the stock price declined and you bought the shares back to cover what you essentially did was go to the market and buy back the shares that you originally borrowed (not the exact same ones, since shares of the same stock are interchangeable, just like money is) and sent them back to the person that lent them to you, thereby closing the transaction.
In a subsequent article I will go over the details of what takes place in real life when selling a stock short but for now it is sufficient to understand the possible outcomes of short selling so that you can incorporate it into your investing or trading strategy.
We already saw what happened when you sold short and the stock that you sold short went down, leaving you with a profit. Now we need to look at the other side of the coin. What happens when the stock that you sold short goes higher instead of going lower. Let's assume that Bank of America goes to $18 and you decide to buy back the shares that you sold short. At this point, because you sold 1000 shares short you would have a loss of $1,600 (plus you need to factor in commisions in your total loss), even though the stock went up.
As you can see, just like everything in the stock market, there is always the possibility of profit and the possibility of loss and this is what keeps the market efficient. For us as investors and traders it is important to incorporate short selling in our list of tools with which to materialize our trading or investing ideas in the market.
As I mentioned before, we will cover short selling and its mechanics in a subsequent article but at this point it is important that you keep in mind the fundamental differences between selling short and buying (going long):
- They are essentially mirror images of each other. When long you profit if the price goes up, when short you profit when the price goes down.
- The potential for profit is completely reversed. When long your potential loss is limited (the stock can only go to $0 and no lower) and the potential profit is (theoretically) unlimited. When going short this is reversed. The maximum profit is limited ($0) but the potential loss is (theoretically) unlimited (a stock price could go higher indefinitely)
- Because you are borrowing shares from someone else, different rules apply with your broker when selling short. For example, you need a margin account (an account where you can borrow money temporarily from your broker using the rest of your assets as collateral).
- Depending on the net value of the assets that you are selling short versus your other assets, you might have to pay margin interest just to keep the short position open (i.e. if you haven't covered it yet). This covers the cost that your broker incurs when borrowing shares for you to sell short since the person who loaned you the shares expects to be paid a fee for this (over and above the shares that need to be returned to him/her eventually)
- The initial proceeds from your short sale while the short position is open will not accrue you interest (the interest that your broker pays you to have the money with them).
- When you want to buy or sell (not sell short) a stock, as long as the market is open you can buy it or sell it. With short selling there might be times when even if you want to sell a stock short there is simply no one willing to loan you the shares that you require to open the position so you won't be able to (you can however, create a similar position with options and we'll talk about that in another article). Your broker will inform you of this at the time when you want to open your short position.
- Once you have your short position open, in general, you decide when to close it (by buying back the shares) and this can be done in the most advantageous manner to your trading strategy. There are times however, when your broker will inform you that some account has called his/her shares back and you will be forced to cover (this could be your whole position or a portion of it). This is called a "forced buy-in" and even though it doesn't happen often (it has never happened to me personally) the potential for it to happen is there.
- When there is a dividend paid out by the corporation, it will go to the new shareholder (i.e. the one who bought the loaned shares from you) but the one who loaned you the shares (and whom you "owe" the shares) also expects a dividend (since they haven't sold out of their position). This all means that as long as you have a short position open you will have to pay out whatever dividend the corporation pays out (this dividend paid by you going to the original shareholder who loaned you the shares). Keep in mind that usually the stock price will reflect the dividend payment by going down in price in the amount of the dividend and since you are short these shares you would make money there. This might offset the dividend that you paid out.
- In terms of voting rights, the shareholder who you borrowed the shares from, in exchange for the fee that he/she receives by lending the shares out gives up the right to vote as long as his/her shares are loaned out. This means that the "new" shareholder (the one who bought the shares that you sold short) will have all the voting rights pertaining to those shares. Remember, the "new" shareholder doesn't even know that the shares he/she bought were shares that were being sold short. In fact, when you buy a stock, chances are that you are buying stock that is being sold short by someone else. There is no way for the buyer to tell them apart and in reality it is immaterial to him/her.