What is Short Selling?

Short selling is the act of selling a stock or other security that one doesn’t own in hopes that the price of the security will fall. This can be done by:

  1. Borrowing a stock through a brokerage firm which usually holds the stock from another customer, normally a pension fund, mutual fund, or even retail investors. A pension fund or mutual fund generally loans out its stock for shorting because it can often collect a fee that shorters sometimes have to pay when borrowing or shorting a stock. If that stock is really in demand in terms of shorting, the borrowing fee can be quite high at times on an annualized basis.
  2. Once borrowed, the short seller immediately sells that borrowed the stock in the open market, and collects cash.
  3. To close the trade, the short seller buys back the amount of shares in the open market and returns those shares to the brokerage firm.
  4. In terms of the final tally, a shorter would make a profit if the the price of the shares that he borrows falls when excluding that borrowing fee. The shorter could lose money if the price of the stock rises.

Due to the borrowing criteria, short selling requires a margin account at a broker. Please note most brokers have the right to call back those borrowed shares at any time.

Why Short Selling is Done

A shorter shorts in hopes that a stock’s price will fall. If the stock price falls, he can make a profit. For example, a shorter shorts by borrowing one share of AAPL from his brokerage at $170, thus collecting $170 in cash with the requirement to repay the brokerage that one share of AAPL at some point (the brokerage might call back those shares at any time, however). Say AAPL reports a bad quarter, and the stock falls to $160. That shorter can then buy back one share of AAPL in the open market at $160 and give it back to the brokerage. He keeps that $10 difference minus the borrowing fees, which should be rather small given AAPL’s size.

Short Selling Can Be Dangerous

A shorter can also lose a lot of money. Say that same shorter borrows a stock of AAPL from his brokerage at $170 again, and again collects that $170 in cash with the requirement to return that one share to the brokerage.

In this hypothetical scenario, AAPL overnight develops AI that cures all the major forms of cancer and that also unlocks safe fusion energy. The news takes everybody by surprise and causes a major gap up to $1700 and a subsequent short squeeze where shorts are basically forced to buy causes AAPL to go to $2500. In this case, a shorter could be forced to buy back AAPL shares at 10x-15x the price he borrowed for, losing $1,530-$2,330 on a $170 short.

There are other events that could cause a short squeeze. If a company is taken over at a major premium and a bidding war emerges, or that company reports a super great quarter and great guidance, the price of a stock could go up a lot, and shorters could lose a lot of money.

Who Does Short Selling?

Due to the potential for unlimited losses, most investors do not do short selling. Some traders do short sell, but mostly in the short term for scalping or swing purposes (Please note we do not think anyone should short sell). Due to their experience, financial resources, and financial goals, many shorts also come from the hedge fund world. Those funds generally spend a lot of time and resources investigating a company’s fundamentals and its future catalysts and then initiate a position. Many hedge funds also hedge with long or option positions, so their short position could be smaller or bigger.

The Takeaway

Short selling is an advanced tactic for bearish investors who think a stock’s price will fall. If a person shorts and that stock’s price falls a lot, he could potentially make money assuming the borrowing costs are less than his equity short profit. For most people, however, shorting is dangerous and could lead to short squeezes.

Read more helpful articles at The Complete Guide to The Short Squeeze: An Educational Article List.

Disclosure:No Positions