Profit on the way down
Stock investors are continually faced with the prospect of their stocks heading in the wrong direction. When investors buy their stocks, they do so with the intention that the stock’s price will increase.
Experienced investors have come to the realization that stock prices do fluctuate quite considerably, but it is when these fluctuations continually head downwards that has investors wondering if there are any tactics that they could use to profit from this decline.
The simple answer is yes and it’s called Short Selling. The basic idea is to sell the stock first and then buy it back later at a lower price. Thus the investor has still managed to buy the stock for less than what it was sold for, even though the stock’s price actually declined.
The question now is, just exactly how does the investor sell something they do not own?
Short selling stock is the process of borrowing the stock from someone else and actually selling their stock. The person the stock is borrowed from (the stock lender) is effectively given an IOU that the investor will return the borrowed stock at a later date. In return for the privilege, the investor agrees to pay interest to the stock lender and agrees to pay any dividends due to the stock lender. The investor further agrees that the stock lender may at their discretion demand that those shares be returned promptly.
Short selling is the process of borrowing stock
from someone else and selling their stock
There are some issues with short selling that the investor should be aware off. These are as follows:
Short selling considerations:
- The stock is generally borrowed from another investor, but may be from the broker’s own holdings. The shares that can be borrowed are placed into a broker inventory list.
- Some stocks are permanently restricted from short selling by the U.S. Securities and Exchange Commission (SEC). The SEC may without notice implement a temporary ban on short selling a particular stock (even if the investor has already short sold it), thus forcing the investor to immediately buy the stock back from the market to close out their short position.
- Even if a stock is permitted to be short sold, there may not be any shares available at the time the investor requires the shares.
- The investor must pay the stock lender interest and the interest rate is determined by supply and demand. The more demand there is for borrowing that stock, then the higher the interest costs and for some hard to borrow stocks the interest rate can be around 100% per year. For easy to borrow stocks, the interest rates may be well under 1% per year. Hence there is a wide range in interest rates and they change dramatically throughout the year.
- Any dividends that the stock lender would have received must be paid by the investor short selling the stock. This is an additional cost to the short seller, however stock’s do tend to gap down on the ex-dividend day and thus effectively lowering the stock’s price to the advantage of the short selling investor.
- The stock lender may recall their stock at any time and without notice. Typically the broker attempts to re-borrow the stock from the broker inventory list, but there is no guarantee that there will be any stock available at that time. Therefore, the investor’s short position may be closed out at a time and price that is not favorable.
- The investor requires a margin account in order to short sell. Cash accounts and individual retirement accounts (IRA) are restricted from short selling.
- Should the stock rally, then the investor may have difficulties in buying stock to cover their short position in order to exit their position. This is referred to as a Short Squeeze and can catch investors off guard (Stocks can rally by more than the value of their short position).
- With buying stocks, the downside risk is limited to the price paid and the upside potential is unlimited. But with short selling, the downside profit potential is limited to a maximum theoretical 100% and the upside loss is unlimited. This makes short selling a high risk tactic unless it is used as a hedging strategy.
Short selling is generally more suited to active investing and is more commonly utilized for short-term investing and trading tactics. Hedge funds and professional traders make good use of short selling which can be quite profitable during bearish market conditions.
Most investors who successfully short sell do not normally short sell in isolation, but rather use short selling in conjunction with other tactics such as spreads, arbitrage and options strategies.
Due to the higher risks and special conditions involved with short selling, it is best left to investors who have the skills and experience to manage this approach to investing. As a general rule, beginner investors who short sell tend to get themselves into a lot of trouble, especially when markets turn bullish again.