The Benefits and Risks of Short Selling

Last Updated: June 8, 2019
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Short selling can be a wonderful feature for professional investors. However, it's riskier than the mere act of buying a stock because the seller opens himself to the risk of unlimited potential losses. Before you're getting into it, here's the main pros and cons of short selling

In plain English, short selling means you are selling something that you do not actually own.A short seller will normally borrow stock through a broker then sell the stock in anticipation of a possible decline in the stock’s price in the future.This means that they will sell the stocks at a high price while hoping that they can buy the stock back when the price goes down.

Short selling is riskier than the mere act of buying a stock because the seller opens himself to the risk of unlimited potential losses. If you buy a stock, the most that you could lose is the price you pay for the stock itself.  For a short seller, he can lose a lot more if the price of the stock goes up.

BenefitsRisks
SpeculationYour Stock Value May Increase
HedgingUnlimited Potential Losses, Limited Gains
Favorable Tax TreatmentInterest Rate Changes Impact
“Buy-in”
Trade Transaction Errors
Margin Call

Short Selling: The Benefits

There are three main reasons why investors short sell:

  • To speculate and take advantage of a stock whose price they are expecting to fall
  • To hedge their long position in the same or similar stocks
  • To avail of a favorable tax treatment

Let’s look a bit in detail at each of these reasons.

Speculation

This is the most popular reason why an investor would want to short a stock.

Some of them might read that the market has overvalued a company, or the company might be releasing some negative announcements or be the subject of a negative publicity – all of which might impact the price downward.  In such case, a short position would provide an easy way to make money as long as the outlook turns out to be correct, of course.

Successful speculation is not guesswork but is the product of intensive and extensive research, experience, and perfect timing. Historically, the stock market tends to go the upward trend.

This means that short sellers are in fact, paddling against the current, so to speak.  The thing is, for aggressive investors, if they short a stock at the right time, they can hit the jackpot.

Hedging

Investors usually short sell their stocks because they want to hedge. In this scenario, they use the hedge as a form of ‘insurance’.  They basically assume an investment position that will protect them from the possibility of a loss.

For instance, if an investor owns shares of Company ABC as his long-term holding.  He could be expecting on the dividends to sustain him during his retirement.  An impending quarterly report might not paint a good picture and may cause analysts and brokers to rethink the stock’s worth, therefore, driving the price lower.

What a short seller will do is to open a short position for the number of shares he already owns.  Doing this will allow him to “lock in” today’s stock price for the shares that he holds.. If you think about it, hedging and the ability to lock your rate is very common in mortgages, commodities, currencies, and many other financial products

If the share price begins to fall, the short position will inversely rise by the same amount.  Should the stock price rise, the investor will lose on the short side but the loss is offset by the shares he already owns.  Experts call this technique ‘shorting against the box’.

Once the company releases its quarterly report and dispels all the uncertainties, the investor will then close out the short position.  He may lose a small amount of money but he will have gained peace of mind and sound sleep – not a bad trade if you look at it.

Come to think of it, hedging is pretty much like buying fire insurance on your home.  The premiums you’ve paid don’t go to waste because your house didn’t burn down this year.  You knew you paid for protection and your life was a bit more peaceful because of that.

Favorable Tax Treatment

Many investors short their stocks to take advantage of the tax benefits it provides to them.  To illustrate:  if an investor owns a stock that has already risen to a value that he is happy with and common sense tells him to sell to make money.

However, if he waits another six months to actually sell it, he gets more in terms of tax advantage because by then, he will only have to deal with a long-term capital gain.

Nevertheless, do take note that although you could short against the box by doing the example above, the IRS has released its guidelines in 1997 disallowing people not to defer taxes in this way.  The exception they allow is shorting a different stock from the same industry or an EFT that represents the same sector.  Yes, it would not be an ideal hedge but if you take advantage of every little thing, you might still be able to reach your goals.

A word of advice to investors though:  it is best to consult your tax adviser or a CPA if you are making stock transactions for tax-avoidance or tax-saving purposes.

Short Selling: The Risks

Your Stock Value May Increase 

If you’ve already shorted a stock, what will happen when its value suddenly goes up? You may feel like kicking yourself but if try to cover the short at a higher price, you may end up losing money altogether.

Unlimited Potential Losses, Limited Gains

When an investor buys a stock, the greatest risk there is losing everything he has initially invested in the stock such as when the stock becomes of zero value.

When an investor shorts a stock, the potential loss is far greater.  Look at this:  suppose an investor shorts a stock at $20/share.  He can make $20 at the most in the transaction if the price of the stock goes down to zero.  However, what if the value of the stock rises to $100 or higher?  It’s obvious that he would have lost at least $80 in the transaction.

And who can tell how much more the price could rise?  This is why it is imperative that you carefully study and market and monitor your short positions before you decide.

Interest Rate Changes Impact

Most investors borrow money to short a stock and if the interest rate on these borrowings unexpectedly and significantly goes up, the investor may end up with an overall loss.

Factors such as the availability of shares drive rates to change daily.  It’s even possible for the rate to change from morning to closing time.  So, any increase in the interest rate will ultimately affect the profit or loss of an investor’s short sale transaction.

 “Buy-in”

There is a possibility that the lender of the stock may decide to pull back the shares that you are borrowing, making the shares unavailable to you.

Of course, any good broker will try to get additional shares on your behalf but if there are no more available shares, you could be in trouble.  Experts call this scenario a “buy-in“.  When this happens to you, the only recourse might be to buy stocks from the open market to cover your short.

If the stock’s value has risen by the time you purchase in the market since the time you originally shorted it, that will automatically be a trading loss.

Trade Transaction Errors

This is how a short normally works – when you execute the trade, your broker will already be sourcing for the applicable shares.

If and when he finds them, that means you will not have the physical stock that you can deliver for settlement and you can execute the trade.  The settlement will happen 2 trading days after your trade takes place but a lot of things can happen.  One is that the earmarked stocks may no longer be available.

If you’re left holding an empty bag, you would have to buy in the open market to cover your trade.  Needless to say, it’s going to cost you a bit more.

Margin Call

If you are going to do a short sale, you need to have a margin account with a broker and that means you have to abide by the rules of your margin agreement.

One of the rules require that you maintain the minimum maintenance margin – otherwise, they will send you a margin call to bring your account’s value up to the limit.  Most brokers require just a 35% margin but some brokers will raise it to 70% if the stocks involved are too volatile.

Market fluctuations may reduce the value of your account and may necessitate the sending of a margin call.  A margin call will require you to add more funds to your account.

If you fail to provide more funds, the broker may do some remedial measures according to your agreement.  He could sell securities in your account or do a buy-in without consulting you – even if it could cause you to lose money.

Bottom Line

Contrary to what many experts are saying, short selling is not all that bad.  It can be a very useful scheme for individuals who know how to use it to their advantage.  Shorting can give you an opportunity to earn a profit when the stock prices are falling.  Every investor should equip himself with sufficient know-how about short selling so he can opt to use it when appropriate.

Short selling is an active trading strategy that comes with its own set of risks.  Do not go into it without preparing yourself for the possibility of losses and without having a concrete exit plan.  Determine ahead what you will do in case things don’t go according to your expectations.

You must also set a profit target for yourself.  The rule is that you can make, at most, a 100% profit in an unleveraged sale although that is extremely rare.  Decide what is a reasonable return for you and close out your trade once you see you’re on target or very close to it.