What is Short Selling?
Short selling isn't terribly complex, but it is a concept that many investors have trouble understanding. In general, people think of investing as buying a security and then selling to make a profit. Shorting is the opposite; you make money only when a shorted security falls in value. Going long on an investment means an investor has bought a stock believing that it’s price will rise in the future. The opposite is going short, which is when an investor anticipates a decrease in share price.
Dividend, interest and margin issue
In order for you to sell short, you must open a margin account. And any dividends or rights declared during the course of your short, you must pay the lender of the stock. Also, if the stock splits during the course of your short, you'll owe twice the number of shares at half the price. And because you are being loaned the stock your broker will charge you interest on the loan and you are subject to rules of margin trading.
Selling short is the sale of a stock that you don't own by borrowing it from your broker. That may sound a little confusing, but it's actually a simple concept. When you sell short a stock your broker will lend you the security. The stock will come from the brokerage's own inventory, another one of the firm's customers, or from another brokerage firm. The shares are sold and the proceeds are credited to your account. Sooner or later you must "close" the short by buying back the same number of shares (called covering) and returning them to your broker. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money.
Most of the time, you can hold a short for as long as you want. You can, however, be forced to cover if the lender wants back the stock you borrowed. They can't sell what they don't have, and so your brokerage will have to either come up with new shares to borrow, or you'll have to cover. This is known as called away. It doesn't happen very frequently, but is possible if many investors are selling a particular security short.
Here is an example of selling short and what can happen. The stock is trading at $100 currently and you think it will trade much lower in the coming months. You decide to take the plunge and short 100 shares. One of two things can happen in the coming months:
The Stock Price Sinks
(stock goes to $40)
Borrowed 100 shares of XYZ at $100 $10,000
Bought Back 100 shares of XYZ at $40 -$4,000
Your Profit $6,000
The Stock Price Rises
(stock goes to $120)
Borrowed 100 shares of XYZ at $100 $10,000
Bought Back 100 shares of XYZ at $120 -$12,000
Your Loss -$2,000
Clearly, short selling can be profitable. But just as with buying long, there is no guarantee that the price of a stock will go the way you want and there are many risks involve in shorting.
The Risks of Short Selling:
I can't emphasize how risky shorting is, well, it's very, very risky.
History has shown that stocks in general have an upward movement and over the long run most stocks appreciate in price. You are betting against overall direction of the stock market, which isn't a good idea.
The potential loss on the short sale of stock is unlimited. This is because a stock can (theoretically at least) rise infinitely. On the other hand, a stock can't go below 0, so your upside is limited. This means that you can lose more than you initially invest, but the best you can earn is a 100% gain if a company goes out of business.
Shorting stocks involves using borrowed money, otherwise known as margin trading. Just as when you go long on margin, it's easy for losses to get out of hand because you must meet the minimum maintenance requirement of 25%. If your account slips below this you'll be subject to a margin call. Then you’re forced to put in more cash or liquidate your position at a loss.
If a stock starts to rise and a large number of short sellers try to cover their positions at the same time, it can quickly drive up the price even further. This phenomenon is known as a short squeeze. Usually, news in the market will trigger a short squeeze, but sometimes traders who notice a large number of shorts in a stock will attempt to induce one. This is the reason it's advisable to not short a stock with high short interest. A short squeeze is an excellent way to lose a lot of money extremely fast.
The final and largest complication is being right too soon. Even though a company is overvalued, it could conceivably take awhile to come back down. In the meantime you are vulnerable to interest, margin calls, and being called away. Academics and traders alike have tried for years to come up with explanations as to why a stock's market price varies from its intrinsic value.
Are there restrictions on selling short?
Shorting is subject to many restrictions on the size, price, and types of stocks you are able to short. For example, you can't short sell penny stocks and most short sales need to be done in round lots.
In addition, the SEC, NYSE, and NASD have rules preventing short selling unless the last trade of the stock is at the same or higher price (known as an uptick or zero plus tick). That is, if you want to short a stock at 110, the short sale can't be made unless the previous trade was at 109-7/8 or lower. These rules exist so that investors can't sell short in a declining market. Continuous short selling on a falling stock will keep forcing it down, damaging the market further.
Two main reason to short:
To speculate - The most obvious reason to short is to profit from an overpriced stock or market. Suppose, for example, you sell short 100 shares of stock priced at $50 a share. When the price drops, you buy back 100 shares at $30 a share, give them back to your broker, and keep the $20-per-share profit (minus commission). Of course, if the share price rises instead of falls, you may have to buy back the shares at a higher price and suffer the loss. Probably the most famous example of this was when George Soros risked $10 billion in 1992 that the British pound would fall and he was right. The following night Soros made $1 billion from the trade, his profit eventually reached almost $2 billion. Very few sophisticated money managers short as an active investing strategy like Soros.
To hedge - Hedging is an investment technique designed to offset, or neutralize, a potential loss on one investment by purchasing a second investment that you expect to perform in the opposite way. For example, you might sell short one stock, expecting its price to drop. At the same time, you might buy a call option on the same stock as insurance against a large increase in value. The majority of investors use shorts to hedge. This means that they are protecting other long positions with offsetting short
Some of the above no longer apply...like the uptick rule. Also, US pennystocks can be shorted through Canada and off-shore.
***END ALL FORMS OF SHORTING NOW***