Shorting a stock is a high risk, high reward strategy. It goes against the market trend. It’s unnatural.
Everyone and their brother wants the market to go up, not the short seller. Shorting a stock is not the popular choice, but there are profits in going against the crowd.
Most of our investments go like this: we buy shares of a stock or ETF. Those shares will rise in value because our research says so. Then we’ll sell, make a cool profit and move to the next investment. That’s the simplified version. Shorting a stock or a short sale is the opposite.
What is a Short Sale?
The SEC defines shorting a stock as:
A short sale is the sale of a stock that an investor does not own or a sale which is consummated by the delivery of a stock borrowed by, or for the account of, the investor. Short sales are normally settled by the delivery of a security borrowed by or on behalf of the investor. The investor later closes out the position by returning the borrowed security to the stock lender, typically by purchasing securities on the open market.
Basically you borrow a stock (or any asset) to sell and buy back at a lower price. The difference becomes your profit.
Lets’s say through the course of your research you find that a stock is overvalued by 50%. It happens. People get excited about a stock and bid up the price higher than it’s worth. We only have to go back to the dot-com bubble for a quick reminder. Eventually, there has to be a fundamental reason for the high stock price. If not, it will correct itself and fall to its appropriate value.
So you decide to short the stock. The process goes like this: you borrow 1,000 shares and immediately sell them at the overpriced amount of $10. You’re now sitting with a $10,000 pile of money. In time, the stock drops in value until it reaches $5. So you buy back 1,000 shares at $5 to return to the lender and pocket a $5,000 profit.
Of course, that’s the simply, risk free version too.
The Risks of Shorting a Stock
The reality is a short sale is very risky. In general, history tells us the market and most stocks tend to rise in value. While the markets are rising in value, shorting the wrong stock can expose you to several risks:
- There’s unlimited downside. The potential for loss is very high. Unlike a regular investment our loss is entirely limited to the amount we put in. Worst case scenario the stock drops to zero and we lose that amount. With a short sale, the price could potentially climb and climb and keep climbing, forcing you to buy back shares at a price several times higher.
- Borrowing shares comes with an interest charge. The higher the demand to short, the higher the interest rate. The costs increase the longer you hold the short position. A high borrowing cost can make shorting too risky and unprofitable.
- There is dividend risk. The lender still wants those dividend payments even though you borrowed and sold their shares. You’re responsible for paying dividends. Since you don’t own the shares, it comes out of the profits or adds to the loss.
- Your short can be called away. If the lender wants their shares back, it forces you to borrow or buy shares to repay the lender. This can happen at any time.
- Timing is everything. You hear it all the time, don’t try to time the market. But with short selling you have to. Getting in too early or too late on a short position will cost you.
Some people are just better at finding overpriced stocks than undervalued ones. There’s nothing wrong with it. Adding a short sale strategy to a small part of their portfolio can bring in additional profits. But it comes with risks.
The short-term trends, momentum and volatility of stocks and the market can play havoc with any investment. It’s even worse when shorting a stock. But it’s still an investment strategy for the right person.