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Convinced that the price of a stock might decline, an investor can borrow the stock from a broker and sell it in the market. The idea is to buy back the stock at a lower price in the future, earning the difference as profit.
This is an investment strategy known as short selling. Betting on a decline in share price can be risky but allow you to express your view on the company.
This article explains how to borrow a stock to short sell, along with the potential risks of short selling.
How to Borrow Stocks for Short Selling
If the stock is available for lending, you'll be able to borrow a stock to short sell. To borrow a stock and short sell, you must first open a margin account with a broker. Here are the steps to get started.
Step 1: Open and fund a margin account with your preferred broker.
You can only borrow stocks using a margin account, which allows you to take positions without always having 100% of the cash required. Margin accounts provide leverage to the investor. However, to keep a margin account open, you must meet minimum margin maintenance requirements. Essentially you need to keep a certain amount of cash or securities collateral with the broker.
Most brokers will require you to have 25% to 35% of the total value of your equity positions. For instance, if you hold $10,000 worth of stock, you must keep a minimum of $2,500 in your portfolio. When your portfolio falls below this amount, the brokerage will issue a margin call, and you have to fund the account immediately or risk having your securities positions sold.
Step 2: Research possible short-selling prospects
Investors typically use a combination of fundamental and technical analysis to identify likely stocks for short selling. Stocks that are overvalued might offer opportunities for short selling. Some signs to screen for when looking for a potential short sell target include:
- Spikes in the price of a stock without an accompanying reason
- Outperformance - A rise in the price of the stock above the rest of the market.
Step 3: Borrow the Stock
The broker borrows the target stock on your behalf from holders willing to lend their stock. You pay interest in your margin account, which is determined by the market. With many stocks, you don’t need to perform an additional step to borrow the stock before short selling. Most of the time when you place a short sell order, the broker will help you borrow the stock without requiring another step.
How to Short Sell Borrowed Stocks
After you have successfully opened the margin account, and located your target stock for short selling, here are the steps to short sell borrowed stocks:
Step 1: Sell the borrowed shares
Place an order to sell shares. If you don’t already own the stock, that means you’ll be borrowing shares to short sell. As mentioned, this process is often happening in the background because the brokerage takes care of it.
You can place a limit order to sell at a predetermined price or a market order to trade at current market prices. Securities that are easier to borrow come with fewer associated costs. It's vital to properly manage the borrowing costs to avoid having them eat into your short-selling profit. Borrow rates can adjust daily according to the market.
Step 2: Wait for the price to move
Wait for the price of the stock you just sold to drop, then purchase the stock to cover the short position. Hopefully, the purchase is executed at a lower price than your short sale price.
Sometimes, the trade could go against you. This happens when the price of the stock rises contrary to your expectations. In that case, you may have to buy the stock at a higher price, which puts you at a loss.
Step 3: Return the stock you borrowed
After buying back the same shares, the broker that helped you borrow the stocks will return the stock to its stock lending portfolio. The broker can also charge interest charges related to the borrowing cost. For shorter term borrow of major stocks, this cost is often very low.
The Risks of Short Selling Stocks
While it sounds straightforward, short selling is speculative and fraught with risks. Here are the primary pitfalls to watch out for.
When you open a long position (i.e. buying shares in the hopes of price appreciation), the risk of loss is limited because the stock can at most drop to zero. When you short sell a stock, the stock price can theoretically rise indefinitely, meaning that your potential for losses is also limitless.
A company may seem overvalued from all indications. But there's no bulletproof way of knowing how long it will take its stock price to drop. While you wait, margin interest keeps piling up, the stock could rise, and you may risk margin calls.
A short squeeze is when the stock you are shorting spikes in price, forcing you to close your position. This phenomenon can be caused by short sellers rushing to close their short positions as the stock prices go up. As more short sellers buy the stock, it can cause its price to rise, leading to a situation where more shorts have to be bought back. The end result is a further spike in stock price.
Compare Brokerages for Short Selling
Investors can short sell through brokerages. Brokerages have stock-lending portfolios that make short selling possible. Benzinga offers insight and reviews on brokerages that offer short-selling capabilities.
Frequently Asked Questions
How long can you borrow stocks to short sell?
How long you can borrow stocks to short sell depends on how long the stock is available for borrowing. However, most of the time, there are no major time limitations for borrowing stocks to sell. However, you have to be mindful of the interest charged on the lending, which accrues every day.
Do you need to borrow to short-sell?
You need to borrow to short sell because you cannot sell shares out of thin air.