What is short selling?

What is short selling?

  • February 28, 2022
  • 172
  • Short selling, or “shorting,” is the act of initiating a sell position in a financial instrument with the intent of buying it back later.
  • A margin account is needed for short selling, as the process involves borrowing the shares to be sold.
  • The main reason to short a stock is to profit from its predicted decline.
  • The biggest risk to short selling is being vulnerable to a short squeeze.
  • Short sellers utilize either fundamental or technical analysis – or a combination – to identify their target.

 

Short selling

If you’ve ever watched “The Big Short” or “Billions” you might have heard of the term short selling. But what exactly does it mean, and how does it work?

Short selling, or “shorting,” is the act of selling a financial instrument, like a stock or bond with the intention of buying it back at a later point in time. It is the opposite of the traditional buy first and sell later process. But, the basic premise of profitable investing – buy low, sell high – is still relevant.

In the context of the stock market, short selling involves borrowing the stock you plan to sell, usually from the brokerage where your account is held, before selling the stock to a buyer. Unlike the traditional buy-and-hold type of investing, this strategy depends on buying back the shares because you must return them to the lender (broker). As the short seller, you would ideally want to do this once the stock has lost value so that you can make a profit, but that is not guaranteed.

Why short a stock?

The main reason to short a stock is to profit from its predicted decline. As the seller, you would have reason to believe that the stock in question is trading at an inflated level and that the market will eventually send its price to a more reasonable, lower level. Clearly, this is subjective, as the market might not share your conviction, in which case you run the risk of losing money.

Market purists believe that short sellers provide a useful service to the market. Aside from providing liquidity (more stock is available to buyers), short sellers are essential to increasing the efficiency of the market. If the short sellers are correct and the shorted stock does decrease in value, then the rate at which it stabilizes is the level of equilibrium between buyers and sellers and, by proxy, the “real” worth of that stock.

Short selling risk

The biggest risk to short sellers is being vulnerable to a short squeeze. This refers to a sudden rush by short sellers to exit their positions en masse. The catalyst is usually some event that results in short sellers questioning their conviction, which leads them to “cover” their shorts (this is what happened during the meme stock frenzy). This act of buying the stock back feeds on itself, intensifying the buying pressure and further pushing the price of the stock up.

Typically, the volatility that ensues with the surge in prices does not last long because there is no fundamental basis to support the sharply higher market valuation, but by then, the damage to the short seller’s account has been done.

Short selling process

There is a process to short selling. Most brokerages allow it but may have their own criteria to identify clients or accounts that are qualified to engage in this risky practice.

  1. The first step is to make sure that your account is cleared to place short selling orders, meaning that all the risk disclosure documents are signed and permissions are granted.
  2. Since short selling involves borrowing, a margin account will be needed as well.
  3. Identify the stock you want to short.
  4. Place the order to short with the broker who will lend the shares and sell them on the open market on your behalf.
  5. When you close out your position, you place an order to buy back and return the borrowed shares to the lender (broker), with the net proceeds either credited to or debited from your account.

Identifying stocks to short

Identifying a stock that is ripe to be shorted is more art than science. Basically, potential short sellers should thoroughly research the stock and vet any piece of information that could influence the outcome of their trade.

That said, most short sellers use either fundamental or technical analysis – or a combination of the two – to pinpoint their targets. Technical analysis tries to predict the direction of prices by studying past market data like price and volume. Fundamental analysis looks at a company’s financial health and might consider a negative earnings surprise or any other event, like a lawsuit, that can portend a decline in the price of the stock.

Short interest ratio

Short interest ratio is an indicator that approximates the time it might take for all the shorts to cover their positions. It is calculated by dividing the number of shares shorted in a company by that stock’s average daily trading volume. The higher the ratio, the more difficult it might be for a short seller to cover their position. There isn’t one standardized number that can be used as a marker, but most short sellers use a short interest ratio range of 8 to 10 to warn them of the rising risk of a short squeeze.

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