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Selling Short: A Strategy for Price Declines
Complicated and Risky, But Sometimes Effective
When you invest in equities, you’re giving a vote of confidence to the stock you purchase because you expect it to add value to your portfolio. You may be anticipating a short-term increase in price so that you can sell your shares at a profit. Or you may be looking for long-term gains from dividends and price appreciation.
But what if you think a stock is going to lose value? If you own shares, you can sell them to protect any unrealized gains or to prevent losses. If you don’t own shares in that stock, you might simply breathe a sigh of relief. But you have another alternative, which, if your assumptions are correct, may enable you to end up with a profit even if the stock price falls. That alternative is to sell the stock short, a strategy you might be hearing about a lot these days but isn’t really appropriate for beginners.
How Selling Short Works
To sell a stock short, you must have a margin account with your brokerage firm, which requires you to meet specific financial requirements and maintain a required account balance determined by the transactions you make. Through that account you borrow shares from your broker and sell them for the current market price, just as you would sell shares that you owned. Then you wait — but not too long, since you’re paying interest on the borrowed shares. If the stock loses value as you anticipated, you cover your short position, or buy shares at the new lower price, and return those shares to your broker.
For example, if you sold 100 borrowed shares when the market price per share was $20 and then bought the same number of shares when the price fell to $12.50, you’d have $750 to your credit ($2,000 sale price – $1,250 purchase price = $750). Your profit is the difference between the amount you received for selling and the amount you paid to purchase, less your brokerage fees and the interest you owe on the borrowed shares.
What Goes Down Might Come Up
When you invest, there’s always risk. Short selling is no exception. In fact, it’s possible to take a bath when you sell short — sometimes a very cold one. That’s because with short selling, timing is critical. Even if the stock price falls, the longer it takes to buy and return the shares you’ve borrowed, the more the interest you’ll pay. Or the price could drop only a fraction of what you expected. Either situation erodes your potential profit or could produce a loss.
An even greater risk is that the price of the stock you sold short could go up, rather than down. If this happens for a brief period and the price increase isn’t too drastic, your strategy may still work. But at some point, your broker may pressure you to return the shares. In this case, you could be forced to pay much more per share than you received when you sold. That loss, plus interest and transaction fees, could be substantial. For example, if you were forced to buy shares for $27 when you’d sold them for $20, you’d have a $700 loss before interest and commissions.
Because short sales are made through your margin account, you also must meet the maintenance requirement. This means keeping cash and marketable securities equal to at least 25 percent of the value of the borrowed shares in your account at all times. (This requirement could be higher, depending on your brokerage firm.) As prices rise, your cost to replace the borrowed shares goes up, and so does the minimum. At some point, you might get a margin call from your brokerage requiring you to add money to your account. If you don’t have the cash, there’s a chance your broker will sell some of your securities to meet the required minimum.
As if this weren’t enough, if the prices of shorted stocks rise, the sellers may find themselves caught in a squeeze. As they scramble to cover their short positions, the stocks’ trading volumes intensify, and the increased demand for these stocks drives their prices even higher. (Editor’s note: For these reasons and because of the relatively complicated nature of selling short, we don’t recommend this strategy for beginners.)
From the Sidelines
If you have a margin account, you may be involved in short selling and not even realize it. That’s because your brokerage firm may borrow shares from your account to provide some of the shares being sold short by other investors who use the same firm.
Although your shares are never at risk — proceeds from the short sales are held in escrow until the shares are returned to their accounts — there’s a potential financial consequence. Any dividends paid on your shares while they’re on loan are taxed at your regular federal income tax rate rather than at the lower long-term capital gains rate that applies to qualified dividends. You may also be unable to vote on issues that are raised at the issuing company’s annual meeting if that vote occurs while your shares are on loan.
One alternative is to use only a cash account if you’re not short selling or buying on margin. You might also consider holding only nondividend-paying stocks and other securities in it.
The Bottom Line
History suggests that it’s reasonable to expect a correction, or period of falling prices, following a period of stock market gains. In this environment, hedgers, speculators and other experienced investors might be able to yield results from some judicious short selling.
Hedgers are trying to protect their portfolios and sell short as insurance against other losses, hoping to come out even or ideally produce a small profit. Spec-ulators, on the other hand, deliberately take risks in the hope of realizing a big return in a falling market. Before you sell short, you need to decide which of these approaches you’re taking, as the consequences can be strikingly different.
Virginia B. Morris is the Editorial Director for Lightbulb Press.