It’s easy to understand that you make money after buying a stock when the stock price increases. Traders who want to profit from a declining market can use a strategy called shorting stock. Continue reading to find out how you short a stock.
What Does it Mean to Short a Stock?
Traders called short sellers use a short selling strategy to speculate on a future market fall of a particular share price.
- Shorting a stock first involves borrowing the stock you wish to sell at a market-determined interest rate and then selling the borrowed equities to take advantage of a future market decline.
- You profit by selling the borrowed stock at a higher price and subsequently buying it back at a lower price if the stock price falls. The profit consists of the difference between the price at which the trader sold the stock and the price they buy it back at less any borrowing and transaction costs.
You can also lose money if the market rises instead of declines as you expected when you initiated the position. This can be particularly problematic and cause something called a “short squeeze” if a large short position accumulates in a stock and significant buying interest subsequently emerges. Retail investors can take action here if they feel comfortable, and they will simply wait as the price declines further.
Stockbrokers generally have a stock loan arrangement with other clients and brokers where the broker pays a certain amount to borrow requested stock, if available. This arrangement allows the broker to use its customer’s stock held in margin accounts or to borrow stock from other brokers to facilitate its other clients’ short sales.
Some market participants feel that this is a form of market manipulation, but it’s akin to seizing on an opportunity. Stocks often don’t fall into a position where shorting will make sense, and that’s it’s not a popular investment strategy.
Typically, the fee for a stock loan on a liquid exchange traded stock is 0.30% per annum. If the stock is difficult to borrow, the stock loan fee could go up substantially. For example, the current fee for a stock loan of GameStop Corp. (NYSE:GME) in late January 2021 is 31% to 38% due to the unusual circumstances the stock is currently in as a result of a massive short squeeze led by small investors.
In 2010, the U.S. Securities and Exchange Commission (SEC) implemented its alternative uptick rule, known as Rule 201, that lets investors in a stock exit their long positions before any short selling can legally occur. The rule becomes active if a stock’s price falls more than 10% in a single day. Short selling is then only allowed “if the price of the security is above the current national best bid.” The goal of this rule is to preserve investor confidence and promote market stability during times of high volatility and extreme selling pressure in a stock.
How Do You Short a Stock?
While it may sound complicated because of the borrowing aspect, the process of shorting a stock is actually pretty easy to put into practice. Shorting a stock can be explained in four simple steps:
- The short seller asks their broker to borrow the stock they intend to sell from a holder willing to loan out their stock. They will need to pay a certain interest rate to the stockholder known as the broker loan rate.
- They then either sell the stock they borrowed at the current market price or they place a limit order to sell it at a specific price and await execution of that order.
- Once the short seller has successfully established a short position in the stock, they can close out that position by buying back the stock in the market, ideally at a lower price. This is known as “buying to cover.”
- The borrowed stock is then returned to the owner with interest via the short seller’s brokerage account along with any dividends earned while the stock was borrowed.
An Example of How to Sell Short
The following example illustrates the concept of shorting stock using a specific company that had dropped significantly in January 2021.
The Company
AcelRx Pharmaceuticals Inc. (NASDAQ:ACRX) is a specialty pharmaceutical company that saw its shares drop by over 16% in late January of 2021. The decline was attributed in large part to the company’s announcement of a secondary stock offering of 14.5 million new shares that would generate an additional $27.5 million for the company. This created quite a lot of downside risk.
Beginning the Short Selling Process
A short seller might expect that AcelRx’s stock price would decline after the stock offering was announced. To take advantage of this anticipated drop, the short seller would contact their broker to borrow the shares they need. As an example, they might ask for a loan of 1,000 shares of AcelRx. The short seller then places an order to sell the borrowed shares at a desired sell price.
The short seller could have sold the borrowed AcelRX stock at $2.80 on January 20 and bought back their short stock the next day for $2 per share. Had they done that, they would have realized a profit of $0.80 per share or $800 on a 1,000 share position.
The Result of Shorting the Stock
After the announcement of the secondary offering, AcelRX stock declined significantly. This gave the short seller the opportunity to cash in their profits the very next day. If the short seller had not covered their short position quickly, the stock’s subsequent rebound may have cost the short seller money instead of allowing them to realize a profit.
Keep in mind that the short seller is liable to pay any dividends received from the borrowed stock to the lender of the stock 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 - dividends paid to stock lender - purchase price of the stock) / Initial margin requirement
In the above equation, the initial margin requirement is the proportion of the total market value of the securities that the short seller has to put up in cash to hold their short position.
A margin account holder can borrow up to 50% of the equity in their trading account for the purchase of new securities or for short sales on normally traded stocks. A margin account also stipulates a maintenance margin that is typically 30% of the equity value. If the account’s equity falls below this maintenance margin level, the broker will issue a margin call to ask the client to take steps to bring the equity back to 50% within a given time frame. If that is not done promptly, then the client’s positions can be liquidated by the broker.
Margin trading accounts have their own set of rules and minimum deposits depending on the broker and the stock you plan on shorting. Remember to check with your broker for information about how much of a particular stock you can sell short in your margin account and what your account’s maintenance margin level is.
Best Online Stock Brokers
Take a look at these recommended stock brokers for your shorting needs.
What to Know Before Short Selling
If you’re considering shorting a stock, make sure you’re informed about your broker’s requirements before you borrow stock to short. You should also be aware of any special circumstances that could make the stock rally before you cover your short position. The following list includes some things you should keep in mind before selling a stock short.
- The security used for shorting should be liquid since illiquid stocks tend to be harder for brokers to borrow.
- A trader who intends to short a stock should maintain a funded margin account with their broker, since margin is needed for shorting a stock.
- Shorting is done by borrowing stock, so the broker will charge interest on that loan to pay to the stockholder. A short seller’s profit earned will be trimmed to that extent.
- Short selling may be restricted on some stocks due to a low supply of available stock.
- Stock borrowing costs can rise significantly under certain market conditions.
- Shorting stocks is not allowed in your IRA account or in any other tax-deferred account.
Using Put Options for Shorting a Stock
Shorting could lead to staggering losses if the shorted stock continues to move higher. A safer alternative to shorting a stock is buying a put option that 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 on ABC stock for $1.50 when it is “at the money” so that the underlying stock’s price is equal to the put option’s strike price, then that gives you the right to sell 100 shares of ABC stock at $50 up until the option’s expiration. You stand to make a profit on that option if the price of the stock drops below $48.50 by expiration since you paid $1.50 to purchase the put option.
When you exercise the put option, you sell the stock at the strike price. You can then pocket the difference between the strike price minus the $1.50 you paid for it and the sale price of the stock.
Alternatively, you can sell the put option contract before it expires. If the market has since declined, you might make a profit on your initial investment. This can sometimes fetch you better returns than what you might gain by shorting the stock, especially if relatively little time has passed and volatility in the stock has risen.
Risks of Shorting a Stock
Before you begin shorting stocks, it’s important to understand all the risks associated with this type of trade.
Beware of a Short Squeeze
One of the key risks associated with shorting stocks is known as a “short squeeze.” This can occur when unexpected positive news concerning the company or the market triggers a notable upward move in a stock that has attracted considerable short interest. This can then send shorts sellers scurrying to cover their positions to minimize their losses.
A perfect example of a short squeeze can currently be seen in the stock of GameStop. Some analysts estimate that the stock has a short interest of almost 140% of the total float of the company’s stock. When short sellers chase the security higher to cover their short positions, demand perks up from technical traders, which can trigger a further sharp rise in the price of a stock.
Another risk that can fuel a short squeeze comes from something called buy-ins. This occurs when a broker is forced to close out a short position in a highly non-liquid stock since the lender demands their security back, perhaps because they want to close out their long position.
Buy-ins and short sellers rushing to cover their positions have thus far pushed the price of GameStop stock to dizzying heights well beyond its fundamental valuation as a company. The massive short squeeze has also bankrupted professional hedge funds that have been short the stock for years.
Despite such pitfalls, shorting as a trading strategy is here to stay, primarily because it offers traders the opportunity to make money even in a downward trending stock market.
Is Shorting Stock Right for You?
Although shorting stocks has its associated risks, the trading strategy can show high returns if done correctly and at the right times. Make sure to carefully perform your research on any stock before initiating a short position. If you’re ready to start selling stocks short, check out Benzinga’s list of the best online stock brokers for shorting.