Short selling a stock is akin to placing a simple bet that a company’s stock price will go down, and as such it’s often demonized as profiting off of failure. However, academics and investors believe that short selling improves market efficiency by making it easier to trade stocks and by ensuring that a company’s failure risk is reflected in its stock price. Here’s a look at how short selling works, and why you should tread carefully if you’re considering trying it.
What is short selling?
Short selling, or shorting, is when you borrow a given company’s stocks using a margin account through a brokerage, then immediately sell them in the hope that the stock price will drop. Later, when that happens, you buy the stocks back at a cheaper price. The stocks are then returned to the original shareholder, who receives a fee. Your profit is made on the difference in the price decline. USA Today has a good example of how this works:
Let’s say Company XYZ stock is trading for $100 and I short 100 shares, so I borrow the shares and receive $10,000 from the sale. If a couple of weeks later, the stock is trading for $90 per share, I can repurchase the stock for $9,000, return the 100 shares to my broker, and keep the $1,000 difference as profit.
If that sounds like getting money for nothing, keep in mind that brokerages charge fees and will charge ongoing interest, just as you’d see with a short term loan. However, a margin account can be kept open for as long as a customer can handle the costs of maintaining the account. And of course, the stock price has to drop, too, and there are no guarantees that will happen.
What are the benefits of short selling?
- Shorting opens up investment opportunities in a bear market, allowing for money to be made not just when a stock goes up, but also when it goes down.
- Institutional investors can use short selling as a hedge (which is essentially a form of insurance) against future bear markets.
- Shorting can reward investors who are good at identifying or uncovering faulty or fraudulent business practices (as an example, the protagonists of the film The Big Short worked as short sellers during the financial crisis).
What are the risks of short selling?
- Short selling is extremely risky, as you’re betting on a future outcome that is hard to predict. A company might be overvalued, but that doesn’t mean it won’t stay overvalued for a very long time. As well, unforeseen events or players can suddenly make what look like safe bets much more risky (consider Bill Ackman’s failed short selling of Herbalife, as an example).
- The potential losses are unlimited, since there’s no upper limit to how high a stock’s price can climb (remember, these stocks have already been borrowed and sold, and they’ll still have to be returned at some point).
- The gains made from short selling are paid out up front, without the benefit of compound interest over time.
- Interest and fees can add up while you wait for the stock to drop, which might never happen (generally speaking, stock prices tend to trend up over time).
Requirements for a margin account
To short a stock, you need open a margin account through a brokerage. When you open a margin account, your brokerage extends a line of credit you can use to buy securities, in addition to your own minimum deposit. Requirements for opening an account may vary, but there are regulatory minimums, per Forbes:
- Before you can begin trading on margin, you must meet the minimum margin requirement. The Financial Industry Regulatory Authority requires you deposit in your margin account the lesser of $2,000 in cash or 100% of the purchase price of the stocks you intend to buy on margin.
- After you’ve purchased securities on margin, you must maintain a certain balance in your margin account. Called maintenance margin or maintenance requirement, it calls for at least 25% of the assets in your margin account to be owned outright by you. If your account falls below this threshold, due to withdrawals or declines in the value of your investments, you may receive a margin call [which can result in the brokerage liquidating your account]
In addition to these requirements, you’ll be looking at monthly interest rates between 4-8%. Of course, the longer you hold on to a short position, the more it costs you. While the chance of reward is great, the risks of short selling shouldn’t be taken lightly.