What is short selling?

The value of your investments and the income you receive from them can go up and down, and you may get back less than you invest. Any examples are for illustration purposes only.

If an investor thinks a company’s stock price will fall they might try to put themselves in a position to profit if it does. One common approach is to borrow shares and sell them at the current price, in the hopes of repurchasing them and giving them back to the original owner at a lower price if the value drops. This is short selling.

Just as there are risks in buying a stock you hope will rise in value (or going ‘long’ a stock), short selling comes with risks too. In fact, short selling carries a higher level of risk than traditional stock purchases. The main reason is that, whereas a stock falling to zero would mean a 100% loss for a long-only investor, losses in short selling are theoretically unlimited, since a stock’s price can rise infinitely. This can put short sellers in a position where they have to spend more to repay the shares than the overall value of the original shares plus any fees associated with borrowing the shares in the first place.

Example

Sam thinks the share price of the fictitious company Watch World is far too high, given a competitor is set to release a revolutionary new timepiece that will dominate the market. Sam uses their margin account and borrows 100 shares of Watch World. They sell the shares at $15 each, the current market price. Now Sam has to wait to see what happens with the stock price. The competitor’s watch is a massive hit and Watch World stock falls 15% to $12.75 per share. Sam buys 100 shares at $12.75 to repay their broker. Before fees charged on the borrowed shares, Sam has made $225 by short-selling Watch World.

To make money in the stock market, you have to buy low and sell high. Short selling attempts to do this but in reverse order. Instead of buying first, you borrow shares, sell them first, and buy them back later, hopefully at a lower price. Once you buy them back, you can return them to the place you borrowed them from.

To short sell a stock (or sell a stock short, or just ‘short’ a stock) you need a margin account (an account authorised to borrow funds or stocks) with your broker. To enable margin investing - including short selling - you will typically go through an eligibility and appropriateness assessment. Regulations set the minimum amount you need to hold in the account and the broker can require even higher minimums. Once you set up the account, there are several steps to short selling.

Read more: Investing with margin

All investments carry risk. Short selling is particularly risky, with theoretically infinite losses, and should not be undertaken by inexperienced traders or investors.

1. Opening the short position: At this stage, you’ll acquire a specific number of shares from your broker and agree to the brokerage contract for borrowing the shares.
2. Sell the shares: Next, you sell the shares of borrowed stock on the stock market.
3. Incubation period: Now begins the waiting game, during which you hopefully see the stock price fall. There is no guarantee that the stock price will drop, so you may have to decide to cut your losses if the price rises instead.
4. Closing the short position: Also called ‘short-covering’, at this stage you buy shares on the stock market to replace the ones you borrowed initially.
5. Reconciliation: If the price of the stock did drop, you have the potential to make a profit but if the stock price has risen, you have the potential to lose money. Once all the buying and selling is done, the profit or loss can be figured out. Any fees for trading, borrowing the shares, or other costs are subtracted from the proceeds of the short sale. Even if the share price dropped, it might not have dropped enough to offset costs associated with short selling.

Brokers get shares to lend to short sellers from several sources. Sometimes the broker has enough shares of stock in their brokerage inventory to cover the loan, sometimes they borrow them from the margin account of one of their customers, and sometimes they go outside the firm to get the shares from another lender.

First, there is the cost of borrowing the shares. If the stock is considered hard to acquire (due to availability or high-interest rates, for example), extra fees may be charged on top of standard borrowing costs. Those rates fluctuate and can range from a fraction of a percent of the value of the stock to over 100% of the stock’s value (on an annual basis). That percentage is prorated by the number of days the short position is open.

If short selling is done on margin (i.e. with borrowed cash) costs such as margin interest and fees also apply. Also, if a dividend or stock split is declared while the short position is open, the short seller may have to reimburse the lender for the value of that dividend or stock split.

While short selling does require a margin account, it is not quite the same thing. When buying on margin, investors borrow cash to help buy securities like stocks or bonds. In short selling, investors borrow and sell the shares themselves. Then, new shares are purchased to pay back the borrowed ones. Short selling generally follows a relatively quick buy-and-sell cycle compared to using margin, which is usually more of a longer-term strategy.

• Unlimited losses: A stock’s price can increase indefinitely, so there’s no limit to how much money you can lose on a short position. Margin requirements are in place to help prevent losses that exceed your account’s available funds, and can lead to margin calls or Robinhood closing your positions. You could lose more money than you originally invested.
• Borrow costs and recalls: When you sell short, you borrow shares to enable your short position. The lender can ask for the shares back at any time (recall), requiring you - or Robinhood - to close your position. The fee you pay to borrow the shares can change depending on market demand and supply.
• Dividends and corporate actions: You owe any dividends or distributions to the lender, even though you don’t own the stock. Special dividends can be large and unexpected. Corporate actions can lead to:
  • Share recalls: The lender may ask for the shares back.
  • Dividend payments: You will be liable to make these payments.
  • Delivery of new shares: This can happen during events like spin-offs. These new shares might be illiquid or hard to borrow if you need to sell them short.
• Short squeezes: A short squeeze is a sharp rise in the price of a heavily shorted stock. It may force short sellers to buy back shares to close their positions, which drives the price up even further. It is often triggered by positive news or strong market momentum.

While there is always the chance of loss, there is also the chance of a gain should the stock price tumble. When combined with buying on margin (borrowing money to buy stock), the potential for a high return on investment (ROI) with a low level of initial capital can seem attractive. However, short selling may actually be used to attempt to offset risk in some cases. Investors sometimes use it as a short-term hedging tactic designed to offset the risk of another investment.

Even if you are not planning on short selling a stock, knowing if others are short selling it can give an insight into the expectations the wider market has for a company. There are two main ways to know if others are shorting a stock. These are the short interest ratio and the days to cover ratio.

1. Short interest ratio: The short interest ratio (SIR), sometimes called the short float, compares the number of a company’s shares currently shorted and the number of stocks available on the market. If the SIR is high, there are a lot of shorted stocks compared to the available stocks - a sign that the stock is likely considered overvalued by other investors.
2. Days to cover ratio: Days to cover ratio, sometimes called short interest to volume ratio, compares the average daily trading volume of a stock to the outstanding shorted shares. It tries to show how many days it would take to cover all the outstanding shorted shares at the average trading volume. Like SIR, a high day to cover ratio generally indicates a general market opinion that the stock is likely considered overvalued by other investors.

Yes, however short selling for the purposes of manipulating the market is not. Short selling (usually in a series of short sales) to create extra activity on a stock, or the illusion of it, falls into the prohibited category. Using short sales to influence others to buy or sell that stock also falls under the prohibited umbrella.

Naked short sales occur when the investor who is selling the stock short is unable to deliver the borrowed shares they traded within a required two-day timeframe for stock settlements. A naked short sale doesn’t always mean that something illegal has happened. A computer glitch, paperwork error, mistakenly issuing physical certificates instead of electronic ones, and other problems could all be legitimate issues affecting the availability of the delivery of shares on schedule. Non-delivery of the promised borrowed stocks is called failure to deliver or “a fail.”

Additional disclosures

Margin investing, including short selling stocks, involves significant risk and is not suitable for all investors. You could lose more than your initial invested capital. With short selling, losses can increase rapidly and may be unlimited. You should only invest in financial products that match your knowledge and experience. Before using margin, customers must determine whether this type of trading strategy is right for them given their specific investment objectives, experience, risk tolerance and financial situation. Margin borrowing increases your level of market risk, as a result it has the potential to magnify both your gains and losses. Regardless of the underlying value of the securities you purchased, you must repay your margin loan. Your broker can change their maintenance margin requirements at any time without prior notice. If the equity in your account falls below the minimum maintenance requirements (varies according to the security), you’ll have to deposit additional cash or acceptable collateral. If you fail to meet your minimums, your broker may be forced to sell some or all of your securities, with or without your prior approval. For more information please see Robinhood Financial’s Margin Disclosure Statement, Margin Agreement and FINRA Investor Information. These disclosures contain information on Robinhood Financial’s lending policies, interest charges, and the risks associated with margin accounts.

Important information

When investing, your capital is at risk. The value of your investments, and the income you receive from them, can go down as well as up and you may get back less than you invest. Forecasts aren’t a reliable guide to future results or returns.

Make sure to do your own research on what investments are right for you before investing or consider seeking expert financial advice. Please note that this article is meant for information and does not constitute any financial advice. This is not an offer, recommendation, inducement or invitation to buy, sell, or hold any securities, or to engage in any investment activity or strategy.