Not all stock trades are straightforward buys or sells. Investors use several different techniques when they make an investment. Many of them — like selling short — are based on the idea that you can make money on a declining stock. The opposite of short selling is buying a stock long. That means you buy stock in a company, believing that it will go higher and then sell it. This is the more traditional route investors take.
Selling short is a way to make money in a stock market by borrowing rather than buying stocks. To sell short, you open an account with a broker. You then borrow shares of the stock that you think will go down in price, sell them in the market and receive the money in your account. If the stock drops as you expect you then have the option of buying the shares at the lower price and repay your broker the number of shares that you borrowed.
For example, you sell short 100 shares of XYZ at $50 a share. The price drops to $25 a share and you buy the 100 shares back, give them to your broker and keep the $25 a share difference as a profit. Buying the shares back is called covering the short position. Because your cost to return the shares is less than it cost to borrow them, you make the profit.
The risks in selling short occur when the price of the stock goes up, not down, or when the process takes a long time. The timing is important because if you borrowed a stock that pays a dividend you must pay your broker the amount of that dividend each time it is paid by the company whose stock you sold short. Thus, the longer the process goes on, the more you pay in dividend expenses—which in turn reduces your total return.
A rise in the stock’s value is an even greater risk. Because if it goes up instead of down, you will be forced—sooner or later—to pay more to cover your short position than you made from selling the stock.
Sometimes, short sellers are caught in a squeeze. That happens when a stock that has been heavily shorted begins to rise. The scramble among short sellers to cover their positions results in heavy buying that drives the price even higher.
Rules require that proceeds from a short sale must be kept on account with the brokerage firm where your account is maintained. The short seller therefore cannot invest these funds to generate income. In addition, short sellers are required to post margin (which is essentially collateral) with the brokerage firm to ensure that the investor can cover any losses sustained should the stock price rise during the period of the short sale.
In short, short selling can be rewarding. However, like all investing, the risks must be clearly understood and mitigated as much as possible.
Quote of the Week: “Hindsight is an exact science.” — Guy Bellamy
Bart Ward is the chief executive officer of Ward & Co. Ltd., an Anoka-based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.