An Overview of Short Selling
At GCI, we think about investing in companies where we anticipate that the stock price will increase. Therefore, we make a profit from the increase in price of the stock. This is called going long on a stock. However, long positions are just one of many ways to profit from the financial market. Short selling is an investment strategy that speculates on the decline of a security’s price. While short selling can take place with any type of security, including bonds or commodities, in this blog post I will focus on just stocks; if an investor believes that a company’s stock will lose value, they can short the stock to make a profit.
How Short Selling Works
In order to short sell a stock, an investor must first borrow the stock from a broker. Brokers are firms that buy and sell stocks for their clients, but they charge commission and interest for their services. In the case of short selling, brokers will locate and obtain the specific stock that the investor would like to borrow and will lend the stock to the investor for a set amount of time. Next, the short seller sells the stock into the market, and waits for the price to decrease. Once the price has fallen, the short seller buys back the stock and returns it to the broker. The short seller profits off of the difference in selling price and buy back price. This process is depicted with a numerical example in the figure below. The short seller borrows shares of a $100 stock from their broker and sells them back in the market. The stock price decreases to $90, and then the short seller buys back the stock at a cheaper price and returns it to the broker. Therefore, the short seller makes a profit of $10/share, minus the interest paid to the broker.
The Players
In order to begin shorting stocks, an investor must open an account with a broker that allows short selling. Not all brokers allow short selling; for example, Robinhood, an online broker, does not allow its users to short stocks. Short selling is more risky than going long on a stock, and so brokers require short sellers to have a margin account, which is an account for investors to deposit money that serves as collateral in case the short seller is unable to pay what they owe. In other words, a margin account serves as an “insurance policy” on the short sell. If the short seller must default on their position, the broker would be able to use funds from the margin account to recover the loss.
Since larger organizations are best suited for dealing with risk and for posting margins, hedge funds are the most frequent short sellers. A specific type of brokerage firm, called prime brokerage, works with just hedge funds. Prime brokers have the resources to locate large quantities of a stock for hedge funds to borrow. Many of the big-name investment banks, such Morgan Stanley, Goldman Sachs, and J.P. Morgan Chase, serve as prime brokers.
Even though the price of a stock might change, the broker is not exposed to any risk from an increase or decrease in price. In order to provide the stock to their client, the broker usually borrows it from a lender, such as an institutional lender or pension fund that has many long positions. The broker is able to borrow stocks from the lender for a very low interest rate, but charges a higher interest rate to their client. The difference between the interest rates at which the broker obtains the stock and lends the stock to their client is called the spread, and brokers try to maximize their spread to make a profit.
Risks
When an investor goes long on a stock, the worst case scenario is that the stock’s price drops to zero. Thus, in a long position, the most an investor can lose is their original investment. This concept is called limited liability, since the investor’s potential loss is limited. However, short sellers are not protected by limited liability. If a short seller is mistaken in their thinking, the value of the borrowed stock may increase significantly. When the broker needs the stock back, the short seller may have to pay even more money to buy back the stock than what they originally invested.
In addition, short sellers are at risk of a short squeeze. When the stock price begins to rise, short sellers will try to buy back the stock in order to cover their position and avoid losing additional money. As short sellers begin buying back the stock, demand increases and the price will increase as well. This may result in a feedback loop, as short sellers lose more and more money.
Managing Risk by Short Selling
Despite the risks of shorting a stock, many investors use this strategy in order to make a profit. However, investors may also short sell in order to protect their other positions. This is called hedging: investors can take offsetting positions to mitigate their losses. For example, if an investor has purchased shares of a particular healthcare stock in hopes that the price will increase, they would look for ways to protect themselves in case the stock price drops to zero. As a solution, the investor may short sell a similar healthcare stock that is correlated to their investment. That way, if the healthcare market declines, the investor is likely to be protected through the short position.
However, short selling poses many risks that might come at a cost to the investor. First, short selling goes against the trends of the market, since stocks tend to increase in value over time. As such, short sellers may be faced with incredible losses if the price of a stock goes up, and especially if a short squeeze takes place. Second, short sellers are responsible for paying any dividends that the company declares during the time of the short position. The short seller must compensate the lender for the dividend, which the lender would have received had they not lent the stock. Finally, investors must consider the cost of interest payments to their broker. The interest payments will always chip away at the profit that an investor hopes to make, and so a small decrease in stock price might not be enough for the investor to break even. Because of these costs and risks, most investors never engage in a short position. However, for investors who have the right risk tolerance, short selling is a good opportunity to diversify and protect their portfolio.