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Short Selling Stocks - How Much Do You Know?

When we come to investing in stocks, most of us are what we called long-only investors. When we say someone goes long, that means they buy a stock of course with the view that it is going to appreciate in price. The intention is to sell it later when the price goes up to cash out their profits. That is your all too familiar buy low sell high. And in terms of process, you buy first and sell later.


Aside from going long, there is another way people can make money from the market. And that is short-selling. We can also say “going short”, or just simply “short”. They meant the same thing so I will be using these terms interchangeably here.


What is short selling?


It should not be too hard to guess because the name already tells you. It is the reverse of going long. In short selling, you SELL FIRST and THEN YOU BUY BACK the stock later. Now, for those who are hearing this for the first time, you might be confused. Why would anyone do that?


Well, you will if you think the price of the stock is going to drop from here. Because then it would make perfect sense for you to sell the security now at what you think is a higher price and then buy it back later when the price becomes lower. And in the process, if your view materializes, you make money from the price drop.


Using TESLA as an example

To illustrate the concept, let me use TESLA in 2022. This is one stock that people either love or hate. And it happens to be one of the best stocks to short last year. By the way, I didn’t short TESLA. This is purely an example.


Example of short selling using TESLA
Example of short selling using TESLA

But let’s just say I got perfect foresight then. And I think TESLA will collapse in 2022. So I shorted 100 shares of TESLA at $352.26. That is the price it closed at the end of 2021. And BINGO! I hit the jackpot because TESLA crashed big time in 2022. I held the stock till this year and I bought the 100 shares back this year at a low of $108.10


For simplicity, if we exclude all the costs involved in putting on and maintaining this trade, I made a profit of $244.16 per share. This is the difference between the price I sold and the price I bought. So in total over the 100 shares, I would have made $24,416 on this short-sell trade.


Difference Between Long and Short


In a nutshell, when you go long on a stock, you are bullish and you are expecting the price of that security to go up. So you buy the stock now and sell it later at a higher price.


And when you short a stock, you are bearish and you are expecting the price of that stock to go down. So, you sell the stock first and buy it back later at a lower price.

Difference between long and short
Difference between long and short

Shorting stocks that you think are going to fall is the most common reason why people want to short stocks. But there are other reasons. For example, some people short stocks because they trade spreads. A spread trade comprises both a long and a short trade at the same time. Others may short stocks because they want to hedge their exposure to the market. But these will be something more complicated if you are a beginner to the financial market. I will be keeping things simple so I will not be covering these.

How Can You Sell Something You Don’t Hold?


Some of you may have noticed this and are scratching your head now. Because when you short, you actually do not hold the stock you are selling. That is what basically short selling is about. If you already hold the stock, then that is not short-selling. That is just simply reducing or closing your positions. So now that begs the question - how can you sell something you don’t hold in the first place?


If you do that, it is called naked short selling. For retail investors, that is not allowed in the US and many other countries. And even in countries where you are able to put on naked short-sell trades, you are likely going to need to close the position within the same day itself.


You need to borrow the stocks you want to short

The usual way to short sell is covered short selling (note: this is not the same as short covering which refers to traders buying back stocks to close out their short positions). That means you need to have the stocks first before you sell. And since you don’t have the stocks, you need to borrow them. And who can you borrow from? Well, you can do so from people who own the stock and are willing to loan them to you. The good news is you don’t have to explicitly look for them and beg them to lend you the stocks. Because your broker will take care of the entire process for you. It all happens seamlessly in the backend.


You pay a borrowing fee to the broker and lender

And why would anyone be so kind as to lend their stocks to you? Because they can earn some extra pocket money. When you borrow stocks, your broker charges you a fee called the stock borrowing fee, stock loan fee, or security lending fee. Depending on the broker, your lender can have a cut on those fees. For those of you who hold a sizable amount of stocks yourself, you may have already experienced your broker inviting you to join their stock lending program. And once you opt in, what happens is that your stocks become part of the pool of available shares for people who wants to borrow and short.


Risks and things you should know about a shorting


Your downside is theoretically unlimited

When you put on a short trade, the payoff structure is the opposite of a long trade. In a long trade, you buy the stock. So in this scenario, your profit is theoretically unlimited. Because the stock price can just keep going up and up. But your loss here is limited to the capital you put up. If the stock crash to zero, then you just lose 100% of that capital.


Payoff Structure When You Long A Stock At $100
Payoff Structure When You Long A Stock At $100

When you are short, things turn around. Your best profit scenario is when the stock collapses to zero. In that event, you will make 100% which is the theoretical maximum profit for a short trade. But your theoretical downside becomes unlimited. Because you lose money when the stock price goes up.


Payoff Structure When You Short A Stock At $100
Payoff Structure When You Short A Stock At $100

Now, usually, before such a drastic thing happens, you will get a margin call and the broker would close out your shorts. But in rare occasions, the stock price may spike up suddenly well before you or the broker has any chance to react.


In case you don’t think that can happen, then you can look up GameStop which was the target of a short squeeze in 2021. It surged almost 140% from its previous day’s close when the market opens on 26 Jan 2021. In the end, the game really stopped for those who shorted which included hedge funds. And if you don't think that is bad enough, there are even more jaw-dropping cases. This is what I read on the web. It was a penny stock called Gateway Industries, a dormant public company back in 2011. I do not know if this stock can be shorted or if there was even any interest or liquidity on it back then. But it rocketed more than 20,000% from 2 cents to almost $3 immediately after it was announced as a subject of acquisition.


You can only short on an uptick when there is a sharp selloff

The rules and regulations governing shorting can be different across countries. As for me, I am only looking at the United States. And in the United States, there is an uptick rule. It comes into force if the stock you want to short is down more than 10% from the previous day’s close. And when that happens, you can only short the stock at a price at least a tick above its latest traded price. So if a particular stock you are looking to short is trading at $10.10 now, that means you can only short it at $10.11. This rule is put in place with the intention of preventing excessive shorting pressure while allowing genuine buyers of those stocks more room to exit their trades during sharp selloffs.


You may not always be able to borrow the stocks you want to short

Some stocks are highly liquid and readily available for shorting. Popular big-cap stocks such as Apple are one example. But not all stocks can be readily shorted as and when you want to. It depends if there are available shares to borrow. Small illiquid stocks or those that are highly in demand for shorting can pose a problem. The famous meme stock GameStop which was heavily shorted before it comes under attack led by Reddit users was one example. It was at one point so heavily shorted that you can’t find any shares to borrow. And personally, I encountered this issue a few times. As a quant who relies heavily on backtesting, this is extremely frustrating. Because not being able to short when your model calls for a short basically means your strategy can be trashed.

The stock borrowing fee can go crazy high

And related to this availability of shares for shorting is the stock borrowing fee which I mentioned earlier. This fee is not a fixed number. It can change based on market demand and supply. If the shorting demand for that stock is high relative to the supply of shares available for borrowing, then the borrowing fee will be high. It is just simple economics. But be wary, because this fee can go crazy high. Again, using GameStop as an illustration, its borrowing fee went as high as 50% annual rate in February 2021. Imagine what that is going to cost you to maintain this trade. As a rough comparison, the average borrowing costs for shorting stocks range between 0.25% - 3%.


Your borrowed stocks can be called back by the lenders

When you short, you borrowed stocks to sell. And when lenders need their stocks back for whatever reasons, say for example, perhaps they sold those stocks off. Then the brokers have to take stocks away from the borrowers and give them back. But this usually does not cause any problem as long as there are still stocks out there that the broker can borrow to replace those that are called away. However, there is a slight possibility that there are not enough stocks at that point in time. In that case, your shorts can be prematurely terminated.


You are up against the market and regulators when you short

Throughout history, shorting always have a bad reputation. In any sharp market downturn, short-sellers will almost always be singled out as a punching bag. As it is, it is already not easy to make money shorting given that the long-term path of the US stock market has always been up. And when what you do is deemed to go against the interests of the majority who are basically long-only investors, more obstacles can stand in your way. So, don’t be surprised if regulators step in to impose further restrictions on shorting or even outright banning it. And they have done that before. US regulators banned shorting temporarily during the Great Financial Crisis in 2008. European countries also temporarily banned shorts during the Covid-19 pandemic in 2020.

That is all I have to share about short-selling. There is quite a fair bit to digest and I hope you learn something of value here. As a final note, as with all investment decisions, do your homework before you short.


You can watch the video version of this post in our youtube channel! Just click on the link below!



 
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