how short selling works
traders commonly engage in short selling for speculation and hedging to open a short position a trader must have a margin account and pay interest on the value of the borrowed shares while the position is open the financial industry regulatory authority finra which enforces the rules and regulations governing registered brokers and broker dealer firms in the united states the new york stock exchange nyse and the federal reserve have set minimum values for the amount that the margin account must maintain known as the maintenance margin 1a broker handles locating shares that can be borrowed and returning them at the end of the trade opening and closing the trade can be done through regular trading platforms with brokers qualified to perform margin trading to short sell traders commonly follow these steps timing and conditionstiming is crucial when it comes to short selling stocks typically decline much faster than they advance and a sizable gain in the stock may be wiped out with an earnings miss or other bearish development conversely entering the trade too early may make it difficult to hold on to the short position in light of the costs involved and potential losses which rise if the stock increases rapidly short sellers commonly look for opportunities during the following conditions short selling costsunlike buying and holding stocks or investments short selling involves significant costs in addition to the usual trading commissions paid to brokers some costs include shorting is known as margin trading traders borrow money from the brokerage firm using the investment as collateral investors must meet the minimum maintenance requirement of 25 if the account slips below this traders are subject to a margin call and forced to put in more cash or liquidate their position 1short selling strategiesimagine a trader who believes that xyz stock currently trading at 50 will decline in price in the next three months they borrow 100 shares and sell them to another investor the trader is now short 100 shares since they sold something they did not own but had borrowed a week later the company whose shares were shorted reports dismal financial quarterly results and the stock falls to 40 the trader closes the short position and buys 100 shares for 40 on the open market to replace the borrowed shares the trader s profit on the short sale excluding commissions and interest on the margin account is 1 000 based on the following calculations 50 40 10 and 10 x 100 shares 1 000 using the scenario above suppose the trader did not close out the short position at 40 but decided to leave it open to capitalize on a further price decline however a competitor swoops in to acquire the company with a takeover offer of 65 per share and the stock soars if the trader decides to close the short position at 65 the loss on the short sale would be 1 500 based on the following calculations 50 65 negative 15 and negative 15 100 shares 1 500 loss in this case the trader had to buy back the shares at a significantly higher price to cover their position the primary objective of hedging is protection as opposed to the profit motivation of speculation hedging aims to protect gains or mitigate losses in a portfolio the costs of hedging are twofold there s the actual cost of putting on the hedge such as the expenses associated with short sales or the premiums paid for protective options contracts also there s the opportunity cost of capping the portfolio s upside if markets continue higher if 50 of a portfolio with a close correlation to the standard poor s 500 index s p 500 is hedged and the index moves up 15 over the next 12 months the portfolio would only record approximately half of that gain or 7 5 investors can choose short selling through exchange traded funds etfs a safer strategy due to the lower risk of a short squeeze put options provide an alternative to short selling by enabling investors to profit from a stock price drop without the need for margin advantages and disadvantagesif the seller predicts the price moves correctly they can make a positive return on investment primarily if they use margin to initiate the trade using margin provides leverage which means the trader does not need to put up much of their capital as an initial investment if done carefully short selling can be an inexpensive hedge a counterbalance to other portfolio holdings a trader who has shorted stock can lose much more than 100 of their original investment the risk comes because there is no ceiling for a stock s price also while the stocks were held the trader had to fund the margin account when it comes time to close a position a short seller might have trouble finding enough shares to buy if many other traders are shorting the stock or the stock is thinly traded conversely sellers can get caught in a short squeeze loop if the market or a particular stock starts to skyrocket a short squeeze happens when a stock rises and short sellers cover their trades by buying back their short positions possibility of high profitslittle initial capital requiredleveraged investments possiblehedge against other holdingspotentially unlimited lossesmargin account necessarymargin interest incurredshort squeezesregulationseach country sets restrictions and regulates short selling in its markets in the u s short selling is regulated by the u s securities and exchange commission sec under the securities exchange act of 1934 regulation sho implemented in 2005 is the primary rule governing short selling that mandates short sales can only be executed in a tick up or zero plus tick market meaning the security price must be moving upward at the time of the short sale 2according to regulation sho brokers must locate a party willing to lend the shorted shares or they must have reasonable grounds to believe that the shares could be borrowed this prevents naked short selling where investors sell shares they have not borrowed 2the sec can impose temporary short selling bans on specific stocks under certain conditions such as extreme market volatility 3in october 2023 the sec added regulations requiring investors to report their short positions to the sec and companies that lend shares for short selling to report this activity to finra 4 these new rules come after increased scrutiny of short selling particularly following the gamestop gme meme stock saga in 2021 when retail investors drove up the stock price causing losses for hedge funds that had shorted the company regulations vary by region the european securities and markets authority esma oversees short selling in the eu positions exceeding 0 2 of issued shares must be disclosed to regulators and those exceeding 0 5 must be publicly disclosed 5 in hong kong the securities and futures commission sfc regulates short selling which is only allowed for designated securities and must be backed by borrowed shares naked short selling is illegal 6