This may be one of those stock market jargon terms that makes you glaze over when you hear it. On the other hand, perhaps now might really be the time to find out, what is short selling on the stock market?
Short selling on the stock market is when you, borrow stock from a broker that you sell now at the current market price because you believe or think that the price is going down. You hope you will be able to buy the stock at a lower market price in the future so you can return the borrowed stock to the broker.
When you borrow stock from a broker, the broker will charge you commission fees and interest. The whole point of short selling is that you expect the gain more money on the difference between the high price you sold the stock at, and the lower price that you paid for the stock at a later time, after you deduct the commission and interest fees your broker charges you in between you selling the stock, short, and you buying back the stock to close your position.
It is much easier to see how this works with a diagram or two.
Short selling – how it works
In simple terms there are three players, i) you, ii) a broker, and iii) the market.
1. The first step is that you spot an opportunity. You see that XYZ Co shares are currently trading at $100 a share and for whatever reason, you are convinced that the price is likely to drop. You decide you are going to sell the shares short. You do your calculations of the probable price levels and how much you are willing to risk and you estimate that you should sell 100 shares of XYZ Co short.
2. You approach a broker, usually your own broker with whom you already have an account that is approved for borrowing on margin. You borrow 100 shares of XYZ Co.
3. You sell the 100 shares in XYZ Co at the market price of $100 per share. At this point, a readout of your account with the broker will show a line with XYZ Co, a quantity of minus 100 and in the value or balance column, a minus figure of $10,000 with any commissions and fees added. In fact, with an online broker steps two and three are achieved with a few mouse clicks.
One month passes. As you anticipated the share price of XYZ Co has now dropped to $80 a share and you expect that it is unlikely to go any lower. Or even if it does go lower you think your prediction has run its course. You decide to close your position and settle your account.
4. You buy 100 shares of XYZ Co at $80 per share.
5. You return the 100 shares of XYZ Co to your broker.
6. Your account is settled. Again with an online broker steps four, five, and six are achieved with a few mouse clicks.
Depending on the margin arrangements for your account, all commissions and interest fees would typically be deducted at this point. The broker will likely charge a commission to open the position when you borrow the shares, commission to close the position when you returned the shares and interest for the duration that you held the position open.
Trading on margin
When you short sell stock you are borrowing the stock from your broker. As that is a loan like any other, your broker will charge you interest. The rates of interest your broker will charge are typically on a scale starting with a higher rate if your account balance is the minimum needed for margin trading to progressively lower rates as your account balance increases.
Margin interest rates are usually about the same or a few points lower than the rate a retail bank will charge you for a line of credit.
Why sell short
When we think of investing in the stock market we tend to automatically think of buying shares at one price in the hope that the price will appreciate and we would sell them at a later date for a profit. That approach predisposes investors to gain from rising prices only.
Short selling stock allows you as an investor to profit from declining stock prices. There are risks involved in short selling that are not present if you are just buying and holding stock expecting to profit from a price increase.
If the price of a stock that you have sold short rises instead of falls, then your broker will usually ask you to deposit or transfer more money as collateral against your short position. Such payments or transfers are called margin calls.
The risk with short selling is that you can end up losing more than you put up as margin. With buying and holding stock you can only lose the amount you paid for the stock.
If the stock price moves against you, you can either make the margin call and close out the position at a loss, or you make the margin call and maintain the position if you still think the price will drop.
There are other ways to profit from declining stock prices, either from buying put options or selling uncovered call options.
Selling short alternative – buying puts
Another potentially less risky way to profit from a declining stock price is to buy put options in that stock.
As the buyer of a put option, you have the right but not the obligation to sell the stock at a set price called the strike price at or before a future date. This is easiest to explain with the same example of XYZ Co stock.
Let’s imagine, again that you see XYZ Co stock is being traded on the market at $100 today and you expect that the price will drop to $80 in about two months from now. You could buy a put option with a strike price of $90 and an expiration date that is three months, or 90 days out leaving you a bit of a time buffer for the price drop to happen.
Each option actually controls 100 shares. Let’s imagine that a put option with a strike price of $90 that is 90 days out could be bought for $5 per share controlled, so would actually cost $500.
Because the strike price of the put option is lower than the market price, it is referred to as out of the money. But because there are still three months to go and the price can change in that time, you actually pay a premium for the option that is reflected in the price.
Options pricing is actually quite complex though it does follow some simple basic principles. The time to expiry, how far the strike price is from the current market price, and the volatility of the stock are all reflected in the option price. Options are also traded during their lifetimes i.e. before they expire and the prices of options changes over time. Effectively the time value reflected in the option decays as the expiry date approaches.
Let’s consider our $90 strike put that still has 90 days to run for which we paid $500. Here’s what that would look like.
If the price does not change at all over the 90 days, then the option price will gradually decrease over time, and when it expires the option will be worthless. There is no value to being able to sell 100 shares of XYZ Co at $90 a share when the market is selling them at $100 a share.
Let’s imagine that like with the short-selling example, one-month passes and the share price of XYZ Co drops to $80 a share, . We could choose to exercise our option to sell at $90 while buying back at $80, so a $10 per share gain or $1,000 for all 100 shares. So we would make $1,000 less the $500 upfront cost of the option less any commission fees.
However, the better thing to do, if we didn’t want to watch what happens for the next 60 days until expiry would be to sell the option in the market. With 60 days to go there would be some time value reflected in the option price. Keeping that math simple, that time value could be as much as $5 per share in the option, so the option would be worth $1,500 at the market.
This is what that would look like.
As we can see in this example short selling actually yielded a higher profit. That isn’t entirely surprising, firstly because the numbers are fictitious, but we should also consider the different risk exposures involved in each approach.
If the price of XYZ Co shares increased rather than declined after you had opened the short position, then you would have received repeated requests from your broker to increase the margin. Let’ say the stock price went up to $150 and you closed the position. That would have cost you $5,000 plus commission and interest.
On the other hand, the risk exposure of the put option is limited to the cost of the put in the first place which was $500.
Real puts – for comparison
As I said the example above used fictitious round numbers. Here is a look at how close a real example would come,
Best Buy Inc. symbol BBY, is currently trading at nearly $100 a share. The $90 put option that expires in 77 days – that is the closest currently to 90 days – costs $3.92. So one put would cost $392.00.
To avoid waiting for a month, hoping almost certainly in vain that Best Buy share price would oblige and drop to $80 for the benefit of our example, we can compare with a BBY put option that is $10 in the money, i.e. with a strike price of $110.00 and expires in 49 days, i.e. a month sooner than the $90 put – which is $10 out of the money. The $110 put option is currently priced at $14.76.
So using this example, we would pay $392.00 and a month later sell the option for $1,476.00, less say $1 in commissions so a profit of $1,083.00. So the real-life example did a little better.
Selling uncovered call options
There is another approach to profiting from declining stock prices. If you have no experience trading options or other financial derivatives this might be a bit of a challenge to get your head around, but here goes.
Rather than selling the stock of XYZ Co short, you can choose to sell call options. This is just taking the opposite side of a call option trade which means you have given them the right to buy the stock. That means you have assumed the obligation to sell the stock. Effectively that means you take on all the risk that the buyer of the call has paid you to take on. If you don’t own the underlying XYZ Co stock, this is referred to as selling uncovered call options. It is like owning a put option but you take on all the downside risk that the purchaser of a put option is avoiding. Really selling a call option is taking on a put obligation.
This sounds like a very risky proposition. If the market moves against you yes this will cost you money. It has one advantage though when you sell either call or put options whether covered or uncovered, you receive the price of the option into your brokerage account. If you know what you are doing and manage your risk well, selling both uncovered and covered call options can be a good way to make income and build your portfolio.
Some questions and answers
Q. What is short selling on the stock market?
A. To short sell, you borrow stock from your broker, then you sell that stock at the current market price. When the market price drops you buy the stock at a lower market price and you return the borrowed stock to the broker.
Q. How do you borrow a stock to short sell?
A. You need an account at a broker that is approved for margin trading. If this is an online broker, once your account is approved you will be able to borrow and short sell with a few mouse clicks.
Q. Is Short selling considered day trading?
A. Day trading is just trading within a single day time horizon. It involves buying and selling long and short positions and closing those positions within the same day. Short selling can be a part of day trading if you choose to use short selling and if your broker gives you that facility.
Q. Who loses in short selling?
A. Short selling is just a part of the supply and demand conditions that determine stock prices. Short selling is only possible if holders of stocks are willing to loan the stock to a short seller. Short sellers add to the volume of orders in the market which contributes to liquidity. If prices drop short-sellers win and stockholders who sell out at a loss lose. If prices rise, stockholders or traders with long positions win and short-sellers lose.
Q. Do you pay interest on short stock?
A. Yes. A broker will charge you interest on stocks that you short sell. The rate of interest will vary depending on the balance in your account. The interest rate charged should be less than you would be charged on a credit card or on a standard checking line of credit.
Q. Why is short selling bad?
A. Short selling is not necessarily bad if you do it responsibly, carefully, and following a well-defined strategy. On the other hand, if you take a wild and reckless approach to short selling you are likely to lose money.
To read about one of the most famous short-sellers of the early 20th century, Jesse Livermore click here.
To learn more about the details and history of short-selling, check here.
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