Short Selling Explained

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Luisa Rollenhagen

Luisa Rollenhagen is a journalist and investor who writes about financial planning for Wealthsimple. She is a past winner of the David James Burrell Prize for journalistic achievement and her work has been published in GQ Magazine and BuzzFeed. Luisa earned her M.A. in Journalism at New York University and is now based in Berlin, Germany.

Short selling is an investment strategy predicated on the idea that the underlying investment will decline in value. It’s a sophisticated and risky strategy that should only be used by investors who fully understand the risks that being wrong on the direction of the underlying securities can entail.

Short selling can be lucrative if the investor guesses right, however the losses can be devastating if the guess is wrong. It’s most commonly done with individual stocks but can be done with ETFs and other exchanged-traded instruments and some commodities.

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How does short selling work?

The investor borrows securities from the inventory of a broker and then sells them to a willing buyer. Investors loaning the securities are often unaware of these sorts of transactions but are never truly “out” the shares as the broker would ensure they have the shares should they desire to sell some or all of their position. (The broker would use shares in inventory elsewhere at the firm to accomplish this.)

The transaction carries a time limit by which the short seller must cover the borrowed shares. This is done by buying the required number of shares in the open market and giving those shares to the broker to cover the borrowed shares.

In order to engage in short selling, the investor must have a margin account with the broker. A margin account allows an investor to take a margin loan in the course of their investing in order to engage in their investing activity. In the case of short selling the loan is the borrowed shares. Margin loans charge interest and require that a certain balance be held in the investor’s account. In the case of short selling their account could require funding to adhere to the margin requirements of the broker.

Confused? Here’s an example: The stock of ABC company is $50 per share. An investor is convinced that the shares will fall in price. The investor arranges to borrow 2,000 shares of ABC to sell short. The investor executes the short sale and agrees to replace the 2,000 shares at the end of three months. A few days before the shares must be replaced the shares sit at $100 per share. The investor is forced to buy 2,000 shares at a cost (ignoring any transaction fees) of $200,000, resulting in a loss of $100,000 on this transaction.

In short selling there is virtually no cap on the potential losses the short seller can incur. The seller must replace the borrowed shares no matter how large their losses are from guessing wrong on the movement of the security’s price.

Naked short selling

With naked short selling, the investor sells shares short that he or she has no connection to. The practice became illegal after the financial crisis of 2008-09 but continues to some extent today due to loopholes in the rules. Naked shorts do not have to be covered by replacing borrowed shares.

Some blame naked shorting for at least part of the stock market crash that occurred during the financial crisis. Many short sellers piled on in the wake of the meltdown in the stocks of former financial giants Lehman Brothers and Bear Stearns.

Inverse ETFs

In recent years inverse ETFs have come into the market. While these ETFs are not technically the same as short selling individual securities, they work in much the same way.

Inverse ETFs use derivatives and other financial instruments to produce daily performance that moves in exactly the opposite direction of the index the ETF is designed to track. The concept of daily performance is critical for investors to understand in using inverse ETFs. The inverse ETFs are essentially rebalanced on a daily basis. These ETFs are not designed to track exactly in the opposite direction of the benchmark index on a long-term basis.

Inverse ETFs are a risky investment that should only be used by professionals or individual investors who fully understand these risks. Investors holding inverse ETFs on a long-term basis should not expect the performance to track in a lockstep opposite direction from the index due to the construction of these ETFs.

For example, the ProShares Short S&P 500 ETF (ticker SH) tracks the S&P 500 on a daily basis, it does so in the opposite direction as the index. If the index rises by 2% in a give day, the ETF will decline by the same amount. Likewise, is the S&P 500 declines by 2% on a given day, we would expect the ETF to gain 2% for that day.

An even riskier version of inverse ETFs are leveraged ETFs. These ETFs make use of financial derivatives to amplify the returns of the underlying index benchmark. An inverse leveraged ETF will amplify the returns of the underlying index in the opposite direction by two or three times.

An example is the Direxion Daily Small Cap Bear 3X Shares (Ticker TZA). This fund is designed to produce three times the daily return of the Russell 2000 index in the opposite direction. For example, if the Russell 2000 gains 2% on a given day, the ETF will lose approximately 6% of its value on that same day.

Inverse and inverse leverage ETFs can be an effective tool for professional traders and money managers who understand how they work, their risks and who are in the markets trading every day. (Most of those reading this article do not fit that description and should think twice—and think twice a second time—before using one of these ETFs.)

The risks of short selling

The risky part is this. The short seller must go into the market and buy enough shares to replace the ones that were borrowed regardless of the current market price. This means if the short seller’s bet on the direction of the share price was wrong, they could suffer a potentially large loss.

In the example in the last section, we saw an investor incur a loss of $100,000 in their short selling bet. In fact, the potential losses are virtually unlimited.

Short selling of stocks or commodities is not an uncommon occurrence. Many stocks consistently are sold short and there is a measurement called short interest. This is expressed as a percentage of the outstanding shares of the stock. The trend on short interest of a stock is a statistic monitored by some stock market analysts.

A situation known as a short squeeze occurs when a security that has been heavily shorted by investors suddenly moves higher. Short sellers may feel uneasy and rush into the market to buy shares to cover their short positions before the price moves even higher. In the case of a stock, a short squeeze might be triggered by a positive development in the company. Perhaps this is the launch of a new product or landing a major new customer. This type of situation can feed on itself. Long shareholders are obviously happy about this change in fortune for the stock.

It’s probably not a good idea to engage in short selling or borrowing on margin to invest. You should only invest money that you have saved yourself.

Investing with a Robo-Advisor

Choosing an asset allocation that fits your goals, time horizon, and risk tolerance is a good approach to investing. Investing in stocks and other asset classes via ETFs or mutual funds is an important part of a diversified portfolio.

Many people choose to invest with a robo-advisor because this approach allows for proper diversification. Robo-advisors invest your money in a mix of stocks and bonds that is appropriate for your situation. If one investment holding goes sour it does not drag down your entire investment portfolio. A robo-advisor can help you determine what your overall asset allocation should be based upon your situation. You just take a short survey to determine your goals and risk tolerance before a personalized portfolio is built for you.

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Last Updated October 30, 2019

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