We all know the feeling when we take a look at our portfolio and it’s all red. It is not too pleasant, right? But what if there was a way to make money even when the stocks are going down? The good news is, there is one. It is called short-selling, which is a popular way to make money on a potentially bearish stock. Let’s see how.
We only advise short selling to more experienced investors due to its risky nature. If you are a beginner, we strongly recommend you gain more experience with trading stocks before you start short selling.
Getting profit from falling stocks – Short selling
Short selling, or shorting in a more popular way, is one technique traders with a margin account can attempt to profit from falling asset prices. But how does it work? To put it simply, it is basically borrowing shares of a stock from your broker and selling them at one price, and then buying the shares back later at a hopefully lower price and pocketing the difference, according to tdameritrade.com. It may sound complicated at first, and the idea of profiting by selling something you do not really own (to be fair you own it for a very short period of time) could sound odd, so let’s see a simple example to help you understand this method of trading.
An example of shorting is – POSITIVE OUTCOME
So, you have done your research and you believe that the price of your chosen stock is going to drop in the future, so you place an order to short for example 100 shares of the stock, and the price of a share equals $100. After that, the broker lends you the shares, you sell them, and you collect $10,000.
After a few weeks, the stock falls to $90, and you decide to cover the short position, which means you buy back the shares and return them to your broker. You buy to cover 100 shares at $90 for a total of $9,000. You keep the $1,000 difference between the selling price and the buy price, minus any transaction costs. This is the positive outcome of short selling.
An example of shorting – NEGATIVE OUTCOME
As we said, shorting could be risky, and this is the reason why. Let’s see what happens when the prices go up.
So, if the same stock rallies from $100 to $110 and you decide to close the position, you would buy back the shares for $11,000, a loss of $1,000. This is the negative outcome of short selling, and if you do not close out of the losing short trade, your risk is technically unlimited, because the stock could continue to rally. This is the reason why short sellers are usually short-term investors.
Why can we borrow shares of a company that everyone expects to fall?
When your broker loans you share for a short sale, they may come from the brokerage's own inventory, another investor, or from a third party like a fund. These other investors may be holding the stock because they have a different outlook on the stock's potential. Or in the case of an index fund, they may be required to hold the shares and choose to lend them out to generate revenue. Keep in mind not all stocks are available for short selling. So, basically, the question was not phrased correctly. If everyone (every broker, trader, investor, fund, etc.) would expect a stock price to fall, short selling would not be a thing at all. Someone has to win.
The risks of short selling
We already know how short selling works, and we have already mentioned the bad side of it. Let’s see what other risks short selling holds.
So, another major risk of shorting is using margins. To short a stock, you need a margin account, which allows you to borrow shares and borrow against your own investments. This may sound complicated, so let’s see an example.
Once you short the shares, your broker will place the proceeds in your account, where they are set aside until you buy back the shares to close the position. This is known as the short balance. At the end of each trading day, a settlement takes place and the short balance changes based on how much the stock price moves based on that day's closing price. If the stock drops as expected, then the money is swept out of the short balance, added to the cash balance, and is then available to trade. However, the profit is not realized until the position is closed.
If there is a loss on the trade, cash is swept out of your cash balance and goes into the short balance. If cash is not available, then the account margin is used, leading to interest charges. The trade moving against you could also result in a margin call.
- Margin calls
A margin call occurs when the account does not meet your brokerage's minimum equity requirements. To meet the margin call you have to deposit cash or securities or close positions to raise the equity in your account. The broker may close positions in your account without regard for profit or loss, and typically reserves the right to do so without prior notice to you. Now you can see what “your risk is technically unlimited” means.
How to avoid it?
- Define your exit signals before you start trading (or when you enter the trade). If things get out of hand, you will know when to stop by phrasing it before.
- Consolidate your accounts. This step will make your investments easier to manage and will increase your available margin.
- Recalling the shares
Besides using margin, another huge risk of short selling is that the lender of the stocks can recall the shares at any moment, which could make you extremely vulnerable. If this happens, you have until 1 p.m. the next trading day to buy back the shares, which could result in a loss.
How to reduce the risks of recalling the shares?
One way to reduce risks is by shorting stocks classified as easy to borrow, which have a lower risk of being recalled. Easy-to-borrow stocks commonly have a high number of outstanding shares that are widely held by other investors and have fewer fellow short sellers.
When looking at a trading platform, you will often see E-T-B when shares are easy to borrow. If no designation appears, contact your broker. A broker may also designate narrowly held stocks with fewer outstanding shares or more short sellers as hard-to-borrow, or H-T-B. B stocks that have available shares may come with a short interest or a hard-to-borrow charge. The short-interest charge is an extra fee associated with shorting. Unlike HTB stocks, easy-to-borrow stocks typically have no short interest.
- Dividends
The last major risk when it comes to short selling is the dividend. While shorting a stock, you do not collect its dividends. Instead, you are responsible for paying dividends to the stockholder. It sounds odd, as we are usually on the other side of the dividends, which means we get it, not paying it.
How to avoid paying dividends?
You can avoid this by not holding your short position through the record date. Do your research and be aware of the important dates of your stock. That could save you from severe headaches.
Summary
If you really know the market and its nature, short selling could be extremely helpful and useful. But, you always have to prepare yourself that when it comes to short selling, a few risks come with it as well. Before you start trading, name your goals, determine your exit signals, and do deep research. That’s how you can make money when the stocks are falling.
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