What’s Short Selling? (Betting Against the Market)

➤ What is short selling?

Short selling is a tactic used by experienced investors to make money when they think a stock’s price will fall. It’s not for beginners (If you are a beginner investor read this first).

Here’s the basic idea: You borrow shares of a stock that you believe will drop in price. Then, you sell those borrowed shares to someone else at the current market price. Later, you buy those shares back at a lower price and return them to the lender. The difference in prices is your profit.

But beware, short selling is risky. If the stock’s price goes up instead of down, you could lose a lot. It’s like betting against the home team in a game – the potential for losses is unlimited.

➤ How does short selling work?

Short selling is a trading strategy where a seller does something interesting – they borrow shares, typically from a broker-dealer, with the hope of buying them back at a lower price to make a profit. Why borrow? Well, you can’t sell shares you don’t actually own.

When it’s time to close the short position, the trader buys the shares back on the market, ideally at a price lower than what they borrowed them for, and then returns these shares to the lender or broker. It’s a bit like renting shares, except with the goal of making money when the price drops.

To start a short position, a trader usually needs a margin account and may have to pay interest on the borrowed shares while the position is open. There are rules set by organizations like the Financial Industry Regulatory Authority (FINRA) and the New York Stock Exchange (NYSE), which define the minimum amount that a margin account must maintain, often called the “maintenance margin.”

If the value of an investor’s account falls below this maintenance margin, they might need to add more funds or the broker could sell the position. The process of finding available shares to borrow and returning them at the end of the trade is managed behind the scenes by the broker.

You can open and close these types of trades through your regular trading account, but each broker has specific requirements that your trading account must meet before they allow margin trading.

➤ Why traders sell short?

People engage in short selling for a couple of key reasons: speculation and hedging.

Speculation means taking a bet that a stock’s price will go down in the future. It’s a bit like saying, “I think this stock is going to fall, so I’ll sell it now and buy it back later when it’s cheaper.”

However, if you’re wrong and the stock goes up, you’ll have to buy it back at a higher price, which means you’ll lose money. Short selling can be riskier because it often involves using margin, which means you’re borrowing to trade. This is usually done over a shorter time frame, making it more about speculation.

On the other hand, you might use short selling to hedge a long position. Imagine you own some call options (which are basically bets that a stock’s price will go up). To lock in profits or limit potential losses, you could sell short against your long position. In simple terms, it’s like a financial safety net.

Hypothetical examples of short selling

For Profit: Let’s say you believe XYZ stock, currently at $50, will drop in the next three months. You borrow 100 shares and sell them to someone else. Now, you’re “short” 100 shares because you sold something you didn’t own but borrowed.

A week later, the company reports terrible financial results, and the stock falls to $40. You decide to close your short position by buying 100 shares for $40. Your profit, excluding fees and interest on the margin account, is $1,000.

For Loss: Using the same scenario, let’s suppose you didn’t close your short position at $40 and left it open, hoping for an even lower price. But a rival comes in and buys the company for $65 per share, causing the stock to soar.

If you decide to close the short position at $65, you’ll incur a loss of $1,500. You had to buy back the shares at a much higher price to cover your position.

As a Hedge: Short selling can also act as a protective shield, especially when you want to safeguard your gains or limit losses in a portfolio.

However, hedging comes with its costs. You need to consider the expenses of short sales or the premiums paid for protective options. There’s also the opportunity cost of limiting your portfolio’s upside potential if markets keep rising.

For instance, if 50% of a portfolio is hedged, and the market goes up 15%, the portfolio would only see about half of that gain, or 7.5%.

Real examples of short selling

Unexpected news events can trigger a short squeeze, a situation where short sellers are compelled to buy shares at any price to meet margin requirements.

Volkswagen

A remarkable instance of this occurred in October 2008, involving Volkswagen.

In 2008, it was widely known that Porsche was actively seeking to accumulate a significant stake in Volkswagen, potentially gaining majority control. Short sellers anticipated that once Porsche achieved this control, Volkswagen’s stock would likely plummet, prompting them to heavily short the stock.

However, a stunning revelation by Porsche changed the game. Porsche disclosed that it had secretly acquired over 70% of Volkswagen’s shares using derivatives. This announcement set off a massive chain reaction as short sellers rushed to buy shares to cover their positions.

Short sellers faced a significant challenge because a government entity owned 20% of Volkswagen and had no interest in selling, while Porsche controlled another 70%. Consequently, there were very few shares available in the market—known as float—for short sellers to repurchase.

As a result, both the short interest and days-to-cover ratio surged overnight, causing Volkswagen’s stock price to skyrocket from the low €200s to over €1,000.

One notable characteristic of short squeezes is their tendency to be short-lived. Within several months, Volkswagen’s stock had retraced back to its typical trading range.

AMC

AMC Entertainment Holdings, Inc. (AMC), a prominent movie theater chain, experienced a short squeeze in early 2021. A group of retail investors, primarily organized through online forums like Reddit’s WallStreetBets, began buying shares of AMC, among other heavily shorted stocks. This coordinated buying activity drove up the price of AMC’s stock significantly.

As the stock price surged, short sellers who had bet on AMC’s stock declining in value were forced to buy shares to limit their losses, contributing to the rapid rise in AMC’s stock price. This situation garnered significant media attention and became a focal point of discussions around retail investor activism and short selling in financial markets.

➤ Pros and Cons of short selling

Short selling has its own set of advantages and disadvantages to consider:

Short Selling Pros

1. Possibility of High Profits: Short selling can lead to substantial profits if the trader predicts price movements correctly. It’s a strategy that can yield high returns.
2. Little Initial Capital Required: You don’t need a lot of money to start short selling, which makes it accessible to a wider range of traders and investors.
3. Leveraged Investments Possible: Short selling allows for leveraged investments, meaning you can control a larger position with a smaller initial investment.
4. Hedge Against Other Holdings: It can act as a hedge to protect your other investments from potential losses.

Short Selling Cons

1. Potentially Unlimited Losses: Unlike buying stocks, where your maximum loss is limited to your initial investment, short sellers can face potentially unlimited losses. A stock’s price can keep rising indefinitely.
2. Margin Account Necessary: Short selling requires a margin account, which involves borrowing funds and paying interest on the borrowed amount.
3. Margin Interest Incurred: Traders must consider the cost of margin interest when calculating their profits.
4. Short Squeezes: Closing a short position can be challenging if there’s a shortage of available shares to buy, especially when many traders are shorting the same stock or if it’s thinly traded. Conversely, short sellers can get caught in a short squeeze if the stock starts to skyrocket.

In summary, while short selling offers the potential for significant profits, it also carries substantial risks. It’s essential to have experience and a good understanding of the market before attempting short selling.

For beginners, short selling through exchange-traded funds (ETFs) may be a less risky option due to lower short squeeze risk.

➤ Short selling risks to consider

Short selling comes with its own set of additional risks and factors to keep in mind:

Shorting Uses Borrowed Money: Short selling involves margin trading, where you borrow money from your brokerage firm using your investments as collateral. If your account falls below the minimum maintenance requirement of 25%, you may face a margin call, requiring you to add more cash or liquidate your position.

Wrong Timing: Even if you believe a company is overvalued, it may take time for its stock price to decline. During this period, you’re exposed to interest costs, potential margin calls, and the risk of being forced to cover your position.

Short Squeeze: Highly shorted stocks with a significant short float and days-to-cover ratio are susceptible to short squeezes. This occurs when the stock starts to rise, prompting short sellers to buy back their positions. This buying can create a feedback loop, attracting more buyers and driving the stock higher, leading to further short covering.

Regulatory Risks: Regulators may impose bans on short sales in specific sectors or the broader market to prevent panic and undue selling pressure. Such actions can cause abrupt spikes in stock prices, resulting in significant losses for short sellers.

Going Against the Trend: Stocks, in general, tend to have an upward trajectory over the long run. Even if a company’s performance remains stagnant, inflation typically drives stock prices higher. Shorting essentially bets against the overall market direction, which historically has shown an upward bias.

In summary, short selling carries unique risks and challenges, including the use of borrowed money, potential timing issues, short squeezes, regulatory actions, and the contrarian nature of betting against market trends. Investors should carefully assess these factors and consider their risk tolerance before engaging in short selling.

➤ Short selling costs

Short selling involves several costs in addition to standard trading commissions. Here are some of the key expenses associated with short selling:

Margin Interest: Short selling requires the use of margin accounts, which can incur interest expenses. Traders may pay significant interest over time, particularly if they maintain short positions for extended periods.

Stock Borrowing Costs: Borrowing shares to execute short sales can result in “hard-to-borrow” fees. These fees are based on an annualized rate and can vary widely, ranging from a fraction of a percent to over 100% of the short trade’s value. The fee is prorated based on the duration of the short trade, and its exact amount may fluctuate from day to day.

Dividends and Other Payments: Short sellers are responsible for paying dividends to the entity from which the stock was borrowed. Additionally, they must cover costs associated with unforeseen events like share splits, spinoffs, and bonus share issues, which can impact the shorted stock.

These costs can significantly affect the profitability of short trades and should be considered when evaluating the potential risks and rewards of short selling.

➤ Short selling metrics

Short selling activity is monitored using specific metrics that provide insights into market sentiment. Two key metrics for tracking short selling are:

1. Short Interest Ratio (SIR) or Short Float: This metric calculates the ratio of currently shorted shares to the total number of shares available or “floating” in the market. A high SIR indicates that a significant portion of available shares is being shorted. It is often associated with stocks that are perceived as overvalued or in a declining trend.

2. Short Interest to Volume Ratio (Days-to-Cover Ratio): This metric is determined by dividing the total shorted shares by the average daily trading volume of the stock. A high days-to-cover ratio suggests that it would take a longer time, in terms of average daily trading volume, for all short positions to be covered or closed. It is considered a bearish indicator for a stock.

These short selling metrics help investors gauge the prevailing sentiment around a particular stock—whether it is bullish or bearish. Monitoring these metrics can provide valuable insights into market expectations and potential price movements.

For instance, in the case of General Electric Co. (GE), a surge in the short interest ratio from less than 1% to over 3.5% in late 2015 signaled increased bearish sentiment. This shift in sentiment was driven by concerns related to GE’s energy divisions and declining oil prices.

Subsequently, GE’s share price declined from its peak of $33 per share in mid-2016 to $10 per share by February 2019. Short sellers who acted on this bearish sentiment had the opportunity to profit from the stock’s decline.

➤ When to sell short

Successful short selling requires precise timing due to the rapid nature of stock declines. Stocks often fall more quickly than they rise, and missing the right timing can result in missed profit opportunities or substantial losses.

Short sellers must strike a balance between entering a trade too late, missing out on potential profits, and entering too early, facing increased costs and risks.

Conditions that improve the odds of successful short selling include:

When we head into a bear market

• Bear markets, characterized by a prolonged downturn in stock prices, are favorable for short selling.
• The overall market trend is downward, increasing the chances of profitable short trades.
• Short sellers thrive in swift, broad, and deep market declines, as witnessed during the 2008-09 global bear market.

When a stock’s (or market’s) fundamentals get worse

• Deteriorating fundamentals of a stock or the broader market, such as slowing revenue or profit growth, challenges to businesses, or geopolitical concerns, can create short selling opportunities.
• Short sellers may prefer to wait for confirmation of a bearish trend rather than anticipating it, as stocks or markets can continue to rise even as fundamentals weaken, especially in the late stages of a bull market.

When technical indicators confirm a bearish trend

• Successful short sales are more likely when multiple technical indicators confirm a bearish trend.
• Indicators may include breaking below key support levels or bearish moving average crossovers, such as the 50-day moving average falling below the 200-day moving average.

When the market gets overexcited and pushes valuations up

• Short selling opportunities may arise when certain sectors or the overall market become overvalued due to excessive optimism.
• This phase, known as being “priced for perfection,” often leads to disappointment when high expectations are not met.
• Experienced short sellers may wait for the market or sector to turn downward after reaching highly elevated valuations.

It’s important to note that short selling involves inherent risks, and timing the market accurately can be challenging. As economist John Maynard Keynes cautioned, “The market can stay irrational longer than you can stay solvent.”

Therefore, short selling is most favorable when several of the above factors align, increasing the likelihood of a successful trade.

➤ Is short selling ethical?

Short selling often faces criticism, with short sellers sometimes portrayed as ruthless operators seeking to undermine companies.

However, it’s essential to understand that short selling plays a valuable role in financial markets by providing liquidity—ensuring there are enough buyers and sellers—and helping prevent the inflation of stock prices due to excessive hype and over-optimism. This role becomes evident in situations where asset bubbles disrupt the market.

Asset bubbles, such as the mortgage-backed security (MBS) market preceding the 2008 financial crisis, are often challenging or nearly impossible to short. Short selling can help prevent the unchecked rise of such assets.

Short-selling activity offers valuable insights into market sentiment and stock demand, serving as a legitimate source of information for investors. Without this information, investors might be blindsided by negative fundamental trends or unexpected news.

Unfortunately, short selling’s reputation suffers due to the actions of unethical speculators who engage in practices like artificially deflating prices and conducting bear raids on vulnerable stocks using short-selling strategies and derivatives. Many forms of market manipulation are illegal in the U.S., but they still occur from time to time.

For those who wish to profit from a stock’s price decline without utilizing margin or leverage, put options provide a viable alternative to short selling.

➤ Short Selling FAQ

Why traders call it short selling

A short position is essentially a bet against the market, aiming to profit when prices fall. When you “sell short,” you’re making this bet. This stands in contrast to buying a long position, where you buy an asset with the hope that its price will rise.

Why short sellers borrow shares

You can’t sell something that doesn’t actually exist. Since a company has a limited number of shares available, a short seller needs to find and borrow some of these shares to sell. The short seller borrows these shares from an existing long investor and pays interest to the lender.

Typically, this process is managed behind the scenes by your broker. If there are only a few shares available for shorting (known as “hard to borrow”), the interest costs for selling short can be higher.

Why some investors consider short selling bad

Although some people view betting against the market as unethical, most economists and financial experts agree that short sellers play a vital role in providing liquidity and helping establish accurate prices in the market. This, in turn, makes the market more efficient.

How to sell short in a brokerage account

Many brokerage firms allow short selling in individual accounts, but you’ll usually need to apply for a margin account first.

Short squeeze and margin call

Because short sales involve margin, even small losses can trigger increasingly larger margin calls. If a short seller can’t meet a margin call, they’re forced to buy back their shares at ever-higher prices. This process drives up the stock’s price further.

➤ Short Selling Quotes

➤ Short Selling: Final thoughts

Short selling provides investors and traders with an opportunity to profit when the market is on a downswing. Those who hold a bearish outlook can borrow shares on margin and sell them in the market, with the hope of repurchasing them later at a lower price.

While some critics see short selling as a bet against the market, many economists argue that it enhances market efficiency and can act as a stabilizing force. Technical traders and analysts frequently examine a stock’s short interest and other short position ratios to shape their trading strategies.

However, large short positions can be vulnerable to short squeezes triggered by margin calls. The buying pressure required to close these short positions can drive prices higher and accelerate a market rally, intensifying losses for short sellers.

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