Profiting from an upward trending market is straightforward and simple. However, to make some bucks from a declining market, traders adopt a strategy called shorting.
What is shorting?
By definition, shorting is the process of borrowing and selling a security that you don’t own in a falling market in anticipation of buying it at later date for a lower price. The profit you pocket is the difference between the money at which you sell the shorted security and the money you expend on buying back the security at a later date.
In this case, the trader makes a profit when the price of a security falls instead of rises.
Basic steps in shorting
Despite the fact that it sounds complicated, the process of shorting is easy to understand and put into practice. The whole transaction can be explained in four simple steps:
- A short seller borrows securities he intends to sell from his broker.
- He sells the securities in the market at the current market price.
- The short buys back the securities from the market at a lower price (if his bet goes right).
- He then returns the loaned securities.
AcelRx Pharmaceuticals, Inc. (NASDAQ:ACRX), a specialty pharmaceutical company, saw its shares cut by more than half on Oct. 12 after the FDA handed it a complete response letter, or CRL, regarding its new drug application for the drug Dsuvia.
The CRL meant the treatment candidate was not approved, and the FDA mandated additional data on safety and changes in the directions for use.
Assuming that a trader knows about the FDA decision, he would know the AcelRx would go down once the decision is announced.
If the trader wants to profit out of this anticipated drop, he would contact his broker and ask the firm to borrow, say, 100 shares of AcelRx. He then sells the shares. At the Oct. 11 closing price of $5.35, the trader pockets $535.
The broker is able to get his client the security he wants to borrow from its own inventory from another broker or from the securities held in the margin account of another client.
With the security tanking post-FDA decision, if our trader decides to cover his short position on Oct. 12, he could have bought it @ $2.15 per share, which makes the outgo for the 100 shares $215. Thus, the trader pockets a neat gain of $320.
On the other hand, if his bet had gone wrong and the stock had risen to $6, he would have been left with a loss of $65.
The short seller is also liable to pay any dividend due to the lender of the stock, the stock which is being shorted.
The formula used for calculating the rate of return on a shorted security is as follows:
Rate of Return = (Sales proceeds from the short sale minus dividends paid minus purchase price of the stock)/ Initial margin requirement
Initial margin requirement is the proportion of the total market value of the securities that an investor, who is buying on margin, has to pay in cash. A margin account holder can borrow up to 50 percent of equity in the account for the purchase of new securities.
A margin account also stipulates a maintenance margin, which is typically 30 percent of the equity value. If the value of the equity falls below this maintenance margin, a broker will issue a margin call, asking the client to take steps to bring the equity back to 50 percent.
Now, the rate of return on shorting AcelRx under the first scenario is 119.6 percent (assuming zero dividend payment and a 50 percent initial margin requirement on the borrowed capital of $535).
Prerequisites for shorting
- The security used for shorting should be liquid, otherwise, it would be difficult for the broker to borrow it on behalf of its client.
- An investor who intends to short a security should maintain a margin account with his broker, as margin is needed for shorting.
- Shorting is done with borrowed capital, so if a broker charges interest on the capital, the profit earned will be trimmed to that extent.
- Short selling is allowed only when the security is on an upswing or is trading flat.
- Shorting is not allowed in securities held in the IRA account or any other qualified or tax-deferred account.
Options for shorting
Shorting could lead to staggering losses if the shorted stock continues to move higher. A safe alternative to shorting is a put option, which gives you the right, but not the obligation, to sell the underlying security at the strike price on or before the expiration of the option.
For example, if you buy one 50 strike put option at the money (underlying stock price is equal to the put strike price), you can sell 100 shares at $50 each. You stand to make a profit when the price of the stock drops below the $50, as you get to buy the stock below the strike price and you can pocket the difference between the strike price and your purchase price.
Alternatively, you can sell the put option contract and make a profit on your initial investment, which will fetch you better returns than what you gain on plain shorting.
Beware of a short squeeze
One of the key risks associated with shorting is a short squeeze, which occurs when an unexpected positive news concerning the company in question or the broader market triggers an upward move, sending shorts scurrying to cover their positions with minimal losses.
When more people chase the security to cover their short positions, demand perks up, triggering a further rise in the price of a security.
There is also something called buy-ins, which means a broker is forced to close out a short position in a highly non-liquid stock, as the lender demands the security back.
Despite the very obvious pitfalls, shorting as a trading strategy is here to stay, primarily because of the opportunities to make money even in an downward-bound market.