Investing in a company’s stock generally means you have an optimistic view of its future. But what about companies that you’re certain will stumble and fall in the near term? While many investors avoid those companies, those with an appetite for risk might choose to sell their shares short.
Short selling occurs when an investor borrows shares of an asset. They then sell the shares—pocketing the money—with the promise of returning the same number of shares in the future. Short sellers hope prices decrease so they can buy back the shares at a lower price and keep the difference. It should be noted that this is an advanced practice that carries high risk. If share values don’t fall, you’re on the hook for buying shares at the higher price!
Short selling is a high-risk, high-reward investing tactic. It tends to be more predictable in bear markets and risk in bull markets. In either case, it’s a tactic that creates a lot of controversy on Wall Street, which can translate to turbulence in your own portfolio. Here’s what investors need to know about the practice of short selling.
An Example of Short Selling
Essentially, short selling involves capitalizing on a company’s poor performance. The best way to illustrate short selling is through example. Consider a bearish outlook on a company that’s already showing signs of regression:
ABC Company has hovered around $50 per share for several weeks. The company’s earnings report is next week and Lily believes the company will miss on expected earnings. She decides to short sell the stock. She borrows 100 shares from her broker and sells them at $50, profiting $5,000. In two weeks, Lily’s theory comes to fruition: the company misses on earnings and the stock plunges to $30 per share on worse-than-expected news and a poor outlook. Lily buys back the 100 shares she borrowed at $30 ($3,000) and returns them to her broker, keeping the $2,000 difference.
The nuances of short selling are often far more complex than this example. The success of a short position depends on the length of time an investor borrows the shares, the outlook and circumstances of the company, and any leveraged buying that goes into the process.
What is a Margin Account and Why Do You Need One?
By law, all short sales must take place in a margin account. This is a special type of account that functions similar to a line of credit. This is because you’re borrowing shares to sell, which means the broker needs to lend them to you. Margin accounts come with many stipulations and investors need manual approval from a broker to open and engage with a margin account.
It’s important to note that because short sales occur in a margin account, it’s not possible to sell short in an IRA or other qualified retirement plan. Investors must sell short in a non-retirement account.
Not only do you need a margin account to execute these trades, a broker must also have inventory and be willing to lend those shares. Most brokers will carry inventory of stocks listed in major indices; however, it may be more difficult to short sell lesser-known stocks.
Keep in mind that not every stock is marginable, either—for example, most webtradetalk.com Reader stocks and foreign shares. Moreover, most brokerage firms have their own restrictions on margin trading, including not lending shares if the price is under a certain dollar amount. It’s best to check with your broker about the capabilities of your margin account and any stipulations for short selling.
How to Mitigate Short Selling Risks
There are many ways to hedge risk when short selling—namely through options. Call options allow a short seller to cover themselves at minimal cost in the event a stock price rises instead of falls.
A call option gives the investor the right to purchase shares of a stock in the future at a specific price point. If an investor short sells a stock, they can protect themselves from price appreciation by buying a call option for a higher price—that way, if the stock goes up, the call option offsets the majority of the increase. While a call option can eat into the profits from a short sale, it can also save investors from staggering losses by greatly mitigating a short sale gone wrong.
Keep in mind that hedging via calls only works for stocks that offer options. Moreover, time decay becomes a factor when involving options. This is all the more reason for short sellers to be swift in exiting their position.
Key Indicators for Short Sellers
How do investors identify short selling opportunities? There’s no one single way to identify when a company’s share price is likely to fall. Instead, seasoned short sellers keep their eyes peeled for collections of indicators that tend to indicate a downward trajectory. Key indicators short sellers look for include:
- Antitrust problems
- Corporate malfeasance
- Heavy debt load
- Industry overcapacity
- Industry-wide image problems
- Lost market share
- Mergers gone bad
- Potential fraud or abuse
- Weak pricing power
The more of these signs present, the more investor sentiment tends to sour. As share price falls, short sellers perform technical analysis to identify potential entry and exit points for their short position. Done right, they can capitalize on decreasing share price to accumulate gains while shareholders count their losses.
Short Selling Carries Tremendous Risk
Betting on a company to do poorly is riskier than assuming it’ll do well. Why? Because short selling involves borrowing and selling what you don’t own, with the intent to pay it back later. If your bet is wrong and the price goes up, you’re on the hook for whatever the difference in price appreciation is. Losing a bet on an uncovered short can quickly put investors in the red for thousands of dollars.
Don’t short sell unless you’re an experienced trader who knows the risks and the nuances of the process. Moreover, don’t sell unless you have a way to hedge the risk. While there’s tremendous potential for profit in short selling, it only comes to those who are careful enough to hedge their bets on a well-formulated hypothesis.
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