Short Selling: How To Short Sell Stocks

2024.04.15 2024.04.15
Short Selling: How To Short Sell Stocks

Alan Tsagaraevhttps://www.litefinance.org/blog/authors/alan-tsagaraev/

One of the most promising trading opportunities in the financial markets is making money from the rise and fall of a trading asset’s price. Public company stock is no exception. 

Being a short seller means selling shares of a selected company to profit from the price difference. A shorted stock is sold at the highest price and bought at a lower price later. You may wonder how an investor or a trader can sell something they don’t own. So, this article will parse the questions related to short sellers in the stock market.

Key takeaways

What is short selling?

To sell stocks short or short selling means selling a company’s stock to make profits.

Let’s say you’re a businessman selling bulk materials. Every morning, you buy cement from a wholesale seller for $10 a bag and resell it for $15 a bag. Your net profit is $3 a bag. You have a market competitor with whom you are on good terms. You also know that your competitor buys cement from the same supplier at the same price. 

Imagine you have had a very efficient day and sold all your cement. Then, a regular client comes up: he needs ten more bags of cement to deliver a project by morning. You know your competitor has the necessary amount. You go to the competitor, borrow ten bags of cement until morning, and sell them to the client at $15 a bag. 

The next morning, you buy cement again from the wholesale supplier at $10 a bag and give 10 bags back to your competitor. Your net profit from this trade is $30. 

Many market participants often mistakenly think that a short position and a short sale are the same thing. A short position means to sell an underlying stock using a derivative instrument — a futures contract, an option, a swap, or a forward contract. A short sale mostly refers to commodities and stocks. It involves directly selling a share borrowed from a broker when the stock rises, returning the share at a lower price, and profiting from the difference in quotes. 

Buying a share back and returning it to the broker are prerequisites for this transaction. That’s why short selling is a risk-on strategy.

How to short a stock

Let’s say you analyze McDonald’s stock. You find out the company’s financials have declined. The latest report shows a slump in demand and revenues. 

Having examined the #MCD chart, you’ve confirmed that the company is experiencing bad times, as technical indicators indicate. The asset’s value is expected to drop shortly.

In this scenario, the algorithm for short selling will be the following:

1. Based on your analysis, the price forms the double top pattern, signaling a price reversal to the downside. Technical indicators and candlestick patterns confirm our assumption that the price will head downwards after breaking the neckline at 279.78. The final target of a short sale is at around 260.68.

2. You plan to sell one share of the issuer’s stock to profit from the difference in rates, but you don’t own that share. Then, you borrow it from the broker.

3. The broker confirms the issuer’s stock can be sold short and lends you one #MCD share.

4. You sell it at 279.78 USD. This money is now in your margin account. Still, you owe your broker one share.

5. Your forecast proves true sometime later, in a week, for example. The price drops to 260.68 USD. Then, you buy back the share, closing your short trade.

6. You return the share to the broker. The short selling profit before expenses is 19.10 USD, but your trade remained open for one week.

7. The broker and the stock exchange charge interest on the trade. Also, you must pay swaps to carry your trade over to the next day during one trading week. 

8. After all expenses are deducted, you net $15.

Why short a stock

Short sellers are mostly market traders and not investors. They short sell for the following reasons:

1. A short seller makes a profit when a stock’s price or a whole stock market declines.

   For example, a trader understands the #MA stock begins to fall from $480 to $400 a share. The trader borrows 100 shares and sells them short at $480 a share. After a while, the price drops to $400, and the trader closes the short sale by buying back 100 shares at $400 a share. The broker gets the shares back while the trader earns $8,000 ($80*100, before interest and brokerage fees).

2. Investors sell short to hedge risks.

   For example, an investor follows a long-term advanced trading strategy and bets on long-term Mastercard Inc stock growth. As the market is cyclic, the stock’s short-term bearish correction occurs. However, the investor doesn’t want to sell the stock and decides to hedge their portfolio by opening a short position using a futures contract or buying a put option. If the price declines, the profit from the short sale will cover the loss from the long position in the long-term investment strategy.

It’s worth noting that experienced investors use both methods simultaneously to profit more when the market falls faster than grows. Large hedge funds most often use such strategies.

Shorting a stock: Example

Financial markets have many stories of successful short sellers. Below are the most striking examples.

1. Paul Tudor Jones

A prominent American billionaire and hedge fund manager, Paul Tudor Jones, foresaw the stock market crash on 19 October 1987, the day later nicknamed “Black Monday.” He noticed that the stock market was highly overvalued, a situation similar to the 1929 financial crisis. Based on historical data on sales in 1929, Paul Jones and his investment company Tudor started short selling aggressively two weeks before the famous “Black Monday.”

By the end of the trading session on 19 October, the Dow Jones index collapsed by a record 22%. The investor and his company managed to make 100 million dollars out of the collapse.

2. James Steven Chanos

American investment manager Jim Chanos became interested in the energy company Enron in 2000. He believed the corporation’s financial performance was greatly overrated. Jim studied all the contradictions revealed in detail and drew the attention of the media.

As a result, a major scandal broke out, and Enron went bankrupt in 2001. Jim Chanos managed to make 500 million dollars out of the fall of Enron stocks.

3. Kyle Bass

Kyle Bass, a major American investor, thoroughly explored the US mortgage market in 2007 and noticed something that many other Wall Street experts did not. A large financial bubble in the mortgage market was about to burst. Kyle began buying credit default swaps, betting against the entire mortgage market. In total, Kyle Bass’ fund earned about $4 billion during the 2008 mortgage crisis.

4. John Alfred Paulson

Just like Kyle Bass, American billionaire and hedge fund manager John Paulson and his partner Paolo Pellegrini researched the mortgage market in the United States. They noticed the emerging problems and attracted independent investors to bet against the housing market. 

John Paulson bought a large volume of credit default swaps from banks and bet on the Big Short. In total, his hedge fund earned about $15 billion  in 2007-2008. John’s personal profit amounted to 4 billion dollars.

Pros and cons of short selling stocks

It is no secret that stock short sellers aim to make quick profits in the stock market. Nevertheless, a short position has its pros and cons, like a long one. Let’s explore the advantages and disadvantages of selling stocks short.

Advantages of short selling

Besides earning quick profits from stock short selling, short sellers can exploit some other advantages:

• a short position (short sale) allows investors to make money in a bearish market;
• short sales help investors hedge risks in long-term long trades;
• short sales allow one to earn more in the short term than with long positions, especially when dealing in overrated stocks.
• an extra opportunity to gain liquidity to invest in other securities and pay off a debt to a broker. That’s particularly profitable amid high volatility.

Disadvantages of short selling

Besides advantages, short sellers may encounter some risks, too.

• Unlimited loss. If your forecast is wrong, and the price hasn’t dropped, you can bear unlimited losses when the stock begins growing in value, as this growth isn’t limited.

• It’s hard to determine short selling entry points. Predicting when the price reverses and starts declining can sometimes be challenging. Short sellers should perform in-depth analysis before making a decision;

• Additional expenses in the form of margin interest charged by the broker. The broker lends securities at a certain interest rate.

It’s worth noting that the wrong prediction can result in a loss-making trade. If a stock’s price climbs, the trader will have to buy the stock back at a higher price, which may lead to significant losses quickly.

So, remember: selling stocks short is a risk-on strategy convenient to experienced market actors with significant capital.

Costs and risks of short selling stocks

Now, we’ll look at the risks and expenses short sellers may face in the stock market.

Potential capital loss

Losses in a short sale are unlimited. You may incur tremendous losses if you incorrectly predict a stock’s price direction and the rate rises.  

Imagine the situation: you decided to sell Raytheon Technologies Corp.’s stocks short at $100 a share. Your capital is $20,000.

You shorted 100 shares at $100 a share. At first, it seems the stock begins to fall, but then the price reverses and skyrockets to $130 a share. The reasons behind such a significant rise could vary from the company’s good financials to large military conflicts, which generally positively impact military stocks. 

To pay off the debt to your broker, you must buy back the stock worth $13,000. Your loss will be $3,000, or 15% of your total capital, plus brokerage fees and interest. A series of such loss-making trades can ruin your margin account entirely.

Short squeeze

A short squeeze is a market situation in which the price of a stock begins to rise acutely due to large buying, knocking the bears out of the market. The buyer’s pressure increases as short trades are closed compulsorily. Short sellers have to close their shorts to return the shares to the broker, thus fuelling demand and raising the price further. That harms all the traders who have outstanding short sales.

Thus, a short squeeze occurs amid insufficient market supply due to a large number of open short trades, and its goal is to increase liquidity by the means of short sellers.

Smaller potential profits

Let’s say the price of a share is $100. Whatever happens, it cannot be worth less than $0. But if the company starts to thrive, one stock price could reach $1,000. That means a potential profit from buying a stock is not limited, while profits from a short position are limited.

Besides, in contrast to long positions, profits from short sales are limited by margin interest charged on borrowed assets or stocks. Short selling can only be done in a margin account. 

Also, shares of some issuers are difficult to borrow because of their limited quantity and high risk rates. 

Standard transaction fees from a brokerage firm and a stock exchange also limit short trade profits.

Long-term uptrend

Stocks usually grow in the long term, with occasional corrections to the downside. This is due to the development of the global economy and the growth of company capitalizations amid increasing demand and purchasing power, productivity growth, scientific and technological progress, and many other factors. Bearish cycles are more rapid and short-lived than growing cycles. So, short selling is more difficult as good entry points for price reversals to the downside are hard to spot, especially because prices drop drastically. The stock market usually collapses fast and unexpectedly.

Sudden change in commissions

Risk rates and margin commissions often change along with the demand/supply ratio. For example, you open a short trade at the rate of 10%. The next day, you find out the rate has grown to 50% and holding the short sale is no longer reasonable. The worst scenario in this case would be the simultaneous stock price growth.

Opening a short sale during dividend cutoff

When short selling, you borrow shares from a broker and become their owner. With dividend payments, a stock usually declines in value in proportion to the dividend amount, forming a gap. 

As a result, your profit will equal the dividend gap, but the gap isn’t guaranteed to equal the dividend amount.

Your trading expenses will be as follows: deduction of dividends, deduction of taxes on dividends, and payment of interest on the borrowed stocks.

In this strategy, the risk of losses increases many times even if the price drops.

Margin trading risk

If the margin for securing a trade in your margin account drops to a critical level (30-35% of the value of borrowed money), the broker can demand that you fund your margin account to cover the margin deficit. 

For example, you’ve sold 100 #RTX shares at $100 a share. Your collateral (margin) is equal to $3,000, provided that the required margin is set at 30% ($10,000*30%). Then, the price soars to $130 a share, and the broker demands that you immediately deposit $900 more to keep your short trade open (margin call). The problem is that you might not have the necessary amount to deposit at a given moment. If you don’t fund the account, the broker can close your trade at a loss to observe the minimum margin requirements and prevent you from losing more.

Most-shorted stocks by short interest

Over 60,000 stocks are traded in global stock markets. Below are the companies with the biggest share of stocks available for short selling.

What is naked short selling, and why is it illegal?

Naked short selling is when market participants short a stock in a stock market without borrowing it from a broker. That is, the stock is not available at the moment of selling.

The process is called naked short selling or naked shorting.

This is an illegal practice, and it has been prohibited in the US, Europe, and some other countries since the 2008 mortgage crisis. Despite all prohibitions, naked short selling is still common.

Naked shorting is used to manipulate the market by inflating it with fake securities and artificially lowering the price. 

Naked short selling is done in two stages:

1. A trader sells shares without borrowing them from a broker, owning them, and securing that right first.
2. Next, the trader buys back the shares at a lower price and returns them, expecting to make profit. The situation where the trader cannot buy back the shares is called Failure to Deliver (FTD).

Here’s a simple example: you want to short sell 100 shares of the Boeing Company. You don’t borrow them from a broker but bet on a decline in their value in the near time. The stock value declines, and you close your short sale at a lower price. Practically, you’ve bet on a price fall, and you will profit from short selling stocks that you never owned.

That’s fine, but what if the price begins to grow? In this case, you will be trapped as you’ll have to buy back 100 shares at a higher price and with a more significant loss. And that’s just half the trouble. You may find yourself in a situation where buying the stock back will be impossible because of insufficient stock liquidity.

Manipulating stock prices through short selling

Stock prices manipulation is a common practice. It has been used numerous times in the history of financial markets, leading some participants to severe losses and others to significant profits.

Here are a few examples of price manipulation in the market.

1. Spoofing and flash crash

In May 2010, the trader Navinder Singh Sarao used this market manipulation scheme, placing multiple orders to sell E-Mini S&P 500 futures. However, he didn’t plan to fulfill those orders, provoking a sharp fall of the stock index futures. Having detected the cascading price decline, algorithmic trading systems started selling assets, making the whole market collapse.

2. Pump and dump

In the early 2000s, the top managers of the energy corporation Enron used fraudulent schemes in their accounting reports to artificially inflate the value of the company’s securities. The company’s false financial statements prompted investors to buy Enron shares. The stock price, having reached its peak, collapsed due to the management’s insider selling, driving many investors to enormous losses.

3. Short squeeze

At the beginning of 2021, some hedge funds actively sold shares of the GameStop company, betting on a price decline. However, the Reddit WallStreetBets community members had the opposite opinion about that company. Traders from Reddit bought GameStop’s shares in a coordinated manner, driving the price up, making hedge funds close their positions at a high price, and provoking huge losses.

4. Wash trading

Wash trading consists in buying and selling an asset simultaneously to increase its market volumes and prompt other traders to invest in the asset. The acute rise in trading volumes attracts traders, driving them to buy or sell the asset. Thus, the asset grows or falls in value.

This manipulation practice is usually applied in the cryptocurrency market. One striking example is a dispute between the Bitfinex exchange and Tether. In this controversy, large players accused each other of wash trading to influence the price of Bitcoin and other cryptocurrencies.

5. Insider trading

Martha Stewart’s case is one of the most striking examples of such manipulation. In 2001, she received insider information that a new drug from the ImClone Systems company failed to get the expected FDA approval. Martha Stewart sold her ImClone Systems shares before the official news release, avoiding serious losses. She was eventually accused of insider trading and found guilty.

Conclusion

Short selling is a way to make money in the stock market. Opening a short trade, a trader aims to sell a stock at a higher price, buy it back at a lower price, return it to the broker and earn the price difference.

It’s important to remember that short selling means borrowing, and you have to pay your broker interest on the borrowed assets. Also, losses may be unlimited and exceed profit. You risk losing all of your capital.

So, parse the price chart and fundamental factors and try to receive as many signals as possible before you short sell.

You can delve into market analysis on a free demo account with the best broker, LiteFinance. A wide array of securities and the company’s multifunctional web platform will allow you to test theoretical knowledge in practice and move to real trading.