Before discussing the benefits of short selling, let’s know what short selling means in the trading market. Short selling is an act of selling borrowed equity shares or shares that do not belong to the seller and are not present in their account. The seller can borrow these shares from the broker. These shares need to be returned to the broker when the seller decides to close their account or during the final settlement. Retail, individual, and institutional investors can short sell.
What is a Short Seller in Stocks Trading?
A short-seller is an investor that sells a stock that he doesn’t own. During short selling, an investor borrows stock from a lender (broker), sells the stock, and then repurchases the stock to return it to the lender. Investors sell “borrowed” stock at the current price when they expect that security’s price will decline in the future.
The seller stands a chance to profit if the prices of the shares that he has shorted decline. In this case, he can rebuy these stocks at the new lower price and ultimately profit. However, the seller will incur a loss if the stock price increases as they have to rebuild the stocks at an increased price. This is why short selling is done when the market has bearish sentiments. Since the sellers are expecting the prices to fall, they can make a profit.
From a traditional perspective, short selling is the exact opposite of conventional trading, where the seller makes a profit only when the stock prices rise. The brokerage on borrowing stocks and the rules of short selling are different for different kinds of assets. Today, we will discuss everything related to stock short selling.
Advantages and disadvantages of short selling
Short Selling Advantages
When you short a stock, you get dual advantages; that is, you can profit irrespective of whether the stock prices rise or fall. Putting you in an advantageous position in every case.
Getting the opportunity to hedge your seller’s profile is one of the many advantages of short selling. You can never be certain about the stability of the market. When you have a diverse portfolio, you get the opportunity to compensate for your losses when in case of financial crises or when there is another bubble pop. Since short selling allows you to gain even when the prices are falling, you would offset any loss that might happen due to market instability. Both advantages are explained below:
- 1. How to Hedge the Seller’s Stock Portfolio Using Short Selling
We like to believe that stocks will only go up irrespective of anything. The truth, however, cannot be far from it. Stock prices do and will go down in some instances. It can happen even when the market is bullish. A fall in the stock price can occur due to many reasons, the most common one being the individual company’s health and its poor performance. It could also happen when an industry falls out of favor, investors have lost faith in it, or more.
Maybe you have added some good options to your stock profile. You think these are real winners, and their value will increase, but this will not happen until others see that potential. It can take years for the stock prices to go up, and some don’t even live up to your expectations. Till the prices show actual progress, you should always keep yourself open to the idea that the prices can go down as well.
If it does happen, having shorts in your portfolio will be of immense help. You would be able to make some profit till the market starts moving your way. Having shorts when the market is bearish can help you to break even. You can even make extra money.
- 2. Taking Advantage of Falling Stock Prices to Make Money
The price movement of stocks is rarely linear. You must have understood this from our previous point. No one can say with utmost surety why that happens, but we can guarantee that you will regret not going short every time this happens. Go short instead of crying about the missed opportunities.
During your research, you will come across many promising stocks and some that are pegged as ‘stinkers.’ Most traders will refrain from investing in these stinkers because their value is likely to go downhill. You can go short on these stocks and make some money by taking advantage of their declining value.
By going short on some stinkers, you will be opening doors for more opportunities. You would be able to make a profit by both falling and rising prices. For many traders, it is a game-changer.
Short Selling Disadvantages
Understandably, you must be prepared to pay some cost and face a certain risk level to gain something in the trading market. Short selling is no different. First, you are required to pay a commission to the broker for short selling as well. Since it is a different trade, your commission for the long position will not cover it. The next disadvantage depends on the stock that you are borrowing. If it is labeled as ‘hard to borrow,’ you will end up paying a daily fee for it till you decide to close the position. If you plan to short sell a dividend-paying stock, you will have to pass on the dividend to that stock’s actual owner. The last disadvantage is the opportunity cost. This is the most overlooked aspect of short selling. There is a margin requirement when you borrow stocks, on which you have to pay the opportunity cost. All four disadvantages are explained below:
- 1. Commission Cost of Broker
The commission is the fees that you pay to the broker for their services. These are not skyrocketing, to begin with. If, anyhow, you do feel that you should look for a different broker or wait till you are financially strong to invest and pay the commission comfortably.
In a long position, you buy first and sell later, and in the short selling, you do just the opposite. From the brokers’ point of view, these are two different kinds of trades that require an equal degree of services on their part. Therefore, you have to pay a commission to the broker for short selling as well. In most cases, the commission for both trades is the same.
- 2. Margin Interest
Margin refers to the stock or the money borrowed by a trader from a broker. As with other forms of borrowings, this one yields interest payment as well. Except for a few, every other broker will charge margin interest on your short position. The rate of interest usually lies between 7-10.5% per annum. This puts an obligation on the trader to make at least a sum equivalent to the margin rate to break even. Be careful with your margin cost.
- 3. Fee on ‘Hard to Borrow’ Stocks
There is an additional fee that is levied on the stock that you might want to short. It is called the ‘stock loan’ fee or the ‘hard to borrow’ fee. Even though it is not an interest that you have to pay, but it behaves like it. There is no fixed or controlled fee. It can be a nominal fee that can even go as high as 100%. When the stock is scarce, this fee can even cost you 300%.
If you are unsure whether you should give such a high fee, do the calculation first. You cannot make more than 100% on shorting a stock when you open a position for no more than a year. If you pay 100% on this stock, you will not make any profit. If you are giving such a high ‘hard to borrow’ fee, you need to be sure about your winning chances; else, you are bound to end up with a huge loss.
In a nutshell, the fee that you will pay for the stock entirely depends on the law of demand and supply. The higher the demand, the higher the fees, and vice-versa.
The fee gets debited every month from your account. The time period starts as soon as you hold the position and runs past the market’s close.
There is a lot of discrepancy with this fee as most brokers refrain from publicly listing the stocks’ names under the ‘hard to borrow’ list. Most brokerages are aware of the high fees associated with these stocks. Thus, they do not even make these stocks available for shorting. If you find a broker who is willing to offer these ‘hard to borrow’ stocks for shorting, ask for all the terms and conditions and the applicable charges before opening a position.
- 4. Dividend Yielding Stocks
If you decide to short-sell dividend-paying stocks, then don’t live in the bubble that you will receive that dividend in your account. Do not forget that the stocks that you are shorting do not belong to you. If you think this is unjustifiable, think about it differently. Suppose you invest in dividend-paying stocks. Your broker decides to loan out some of these stocks to a short seller. You will not be concerned with what that short seller made or lost; you will be expecting the dividend due on your shares in your account. Would you let this dividend go? We don’t think so!
The company will pay the dividend to the final owner of its shares, in this case to whom you sold the shares. It is not going to run its bots through the grapevines to find the actual owner. The person who bought the shares from you with the hope of getting the dividend will get the dividend from the company, but you still owe the same dividend to the person from whom you borrowed these stocks. Paying them their due dividend is your liability.
Let’s assume that you sold short 200 shares. The company announces a $2.00 dividend. Now, you owe the lender $400. This is in addition to other fees that you might incur.
- 5. The Opportunity Cost
The maintenance margin requirement for short selling is higher. This is because short selling is different from traditional trading and comes with a lot of potential downsides. Since there is a lack of surety, your broker will ask you to maintain a certain sum in your account for unforeseen problems.
This margin requirement is 50% of your position value. You need to maintain this sum in your account at the time of opening a position. For example, for short selling 200 shares at $40 per stock, you will be required to deposit $4000 in your margin account as the total value of the position you want to open $8000.
This margin value is not fixed. In case the stock goes up, your broker might decrease the margin requirement to 30% to 40% of the position value. When the stock prices increase, your position value also increases. Even after decreasing the maintenance margin percentage, there are situations in which you need to deposit more cash to your margin account because the value has grown too much, and your initial deposit cannot cover it. In this case, you might get a margin call, asking you to deposit more money. If you fail to do so, your broker will close your position, buy back the shares that they lent to you, and you will have to suffer a loss.
If things go according to your prediction and the stock prices go down, you will be required to maintain 50% of your margin account’s position value. As the value will keep declining, more cash from your account will get freed up.
Stock Short Selling Example
Let’s assume that after keeping an eye on a company’s stocks, say ABC; you are convinced that its prices will fall. It could be because of any reason, but you are hopeful that you would make a profit by shorting its stocks. Therefore, you decide short selling 100 shares of ABC.
To keep things simple, let’s assume that your broker is not charging you the hard-to-borrow fee or margin interest. Let’s also believe that your initial margin requirement is 50% of the position value, and the maintenance margin requirement is 30%. We are also neglecting any dividends associated with ABC stocks.
According to your calculations, these stocks will tank fast and hard, and opening a position for just a few days makes more sense.
Suppose ABC, at the time you open the position, is trading its stocks at $31.00, and you borrow 100 shares to sell in the market; here is the table of balances for your reference:
Shorted Shares: 100
Shorted Price: $31.00 per stock
Initial Value of the Position: $3100.00 ($31.00 x 100)
Initial Margin Deposit: $1550.00 (50% of $3100.00)
Opening Margin Account Balance: $4,650.00 ($3100.00 + $1550.00)
Margin Call Price: $35.77 ($4,650.00/130%/shorted shares)
The above table includes a crucial term – margin call price. This is the point at which you can expect to receive a call from your broker, asking you to deposit more money in your margin account.
The above explanation is essential. The amount will keep changing by the price fluctuation of the stocks.
Explaining the Short Selling Example
To have a better grasp of the value that we have calculated in the above table, you need to have a clear understanding of the following terms:
- Maintenance margin requirement increases and decreases with the fluctuation in stock prices. If the prices go higher, you will be required to deposit more money with the broker if you get a margin call. Conversely, if the value goes down, some of the money in your account will be freed.
- You will always get the value of your initial margin deposit by subtracting profit from equity.
- To get the balance of your initial margin account, add the value of the current position, maintenance margin, margin call amount, and the margin amount released.
- You Initial margin account balance will always be equal to the margin call amount, the current margin balance, and the margin call amount.
How to Minimize the Risks Involved in Short Selling
Short selling adds to your portfolio and allows you to profit even when prices are going down. However, like other types of trading, this one is not free from risks either. These risks can be minimized to a great extent by understanding all the trading terms and considering all the pros and cons. Another way to reduce risk is by decreasing the cost of trading. Look for a broker that does not charge margin interest.
Unless you are particular about a stock or wish to open a short position for a significant period, not invest in ‘hard to borrow’ supplies. They unnecessarily increase the cost of trading. In addition to that, avoid dividend-paying stocks as they increase your liability towards the lender. And high dividend-yielding stocks should be absolutely off the list unless you have insider information (which is illegal).
Short selling is different than traditional trading. If you are a new trader, you should stick to conventional trading. If you still wish to short some stocks, buy the inexpensive ones first. It is always better to clear the terms of trading with the lender before opening a position. There are many hidden costs in short selling; consider those before borrowing from your broker. Open the position only after considering both the advantages and disadvantages of short selling.