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Introduction to short selling: How to bet against a stock?

Introduction to short selling: How to bet against a stock?

Many of you have probably heard of the Gamestop saga. A lot of hedge funds were short selling Gamestop stocks. And some investors found out about that and decided to fight against the big hedge funds by massively buying into this stock.

But what is shorting a stock? When you are shorting a stock, you are betting against this stock. But why and how to do that?

Even though I am not a short seller, I think it is interesting to learn about this. And I know many of my readers are interested in some more advanced investing techniques. So, let’s delve into short selling!

Short Selling Stocks

The concept of short selling is actually relatively simple. It is also sometimes called shorting a stock. So, shorting and short selling are the same thing.

But first, let’s start with the contrary, holding shares for a long time to profit from the stock market going up. This is called a long position. A long investor buys shares of a company hoping to sell it for a profit in the future. This is as simple as it gets:

  • The investor buys shares of a stock at X USD
  • In the future, the investor sells the shares of a stock at  Y USD. And if Y is greater than X, the investor made a profit on its operation.

Now, a short seller does the contrary. Such an investor starts by selling a share that he does not have. And then, in the future, it buys back the share. It is actually simple as well:

  • The investor sells shares of a stock at X USD
  • In the future, the investor buys back the shares of a stock at Y USD. If Y USD is lower than X, the investor made a profit.

Now, how do you sell something you do not have? You borrow it! In short selling, the shares are borrowed and then sold. While the investor holds the shares, he pays interest to the lender (generally the broker) and then reimburses the loan once he buys back the shares.

A long position is for betting on the stock going higher, while a short position is for betting on the stock going lower.

When the investor buys back the shares, it is said that he is covering the short.

Another reason to short a stock would be to hedge against the risk of the market going down. If you are worried about the market going down, you could short a portion of your portfolio. This way, you would limit the risks if the market goes down, but you would also limit the gain if the market goes up. So, this is an advanced technique that some people are using.

I am talking about stocks here, but you could bet against an entire index by short selling shares of ETFs.

If you are looking into the metrics of stock, you may find something called short float or Short Interest Ratio (SIR). This indicates the ratio of shares that are being shorted compared to the total number of shares available. This is generally a good indicator of how positive or negative the investors in this stock are. If only 10% of the shares are being shorted, it could indicate positive sentiment. If 90% of the shares are being shorted, it is likely to indicate negative sentiment.

Borrowing Shares

You cannot short sell a stock without borrowing a share. So, how we borrow a share?

Borrowing a share is generally as easy as selling shares that you do not have with most brokers. But there are a few things we need to consider.

First, for borrowing a share, there need to be shares available. The broker cannot make a share appear out of thin air to loan it to you. So, some investors with long positions are lending their shares to short-sellers.

Also, you do not borrow directly from the lender. The broker acts as an intermediary. And you generally do not know from whom you are borrowing shares.

When you borrow shares, you get a loan from the broker. And you will have to pay interest on this loan. Generally, the interest rate is very low on these loans, often less than 1% a year. And you will pay this to the broker. Many brokers will keep all this revenue for them. But some brokers, like Interactive Brokers, will give back some of this money to the lender.

Keep in mind that to borrow shares, you need to have a margin account with your broker. And you need to make margin requirements. This means you need to have enough cash and shares to cover some part of the loans’ value. Often, you have a 25% margin requirement. This requirement will depend on the broker and the local regulations.

Since investors are paying interest on the borrowed shares, short selling is generally a short-term play. But in theory, the borrower could keep the shares indefinitely, as long as he meets the margin requirements.

As a side note: before the 2008 financial crisis, in the United States, it was actually legal to short sell shares without having them. This is called naked short selling. But this is now illegal in most countries. And in some cases, some countries have even banned short selling for some periods of time. For instance, China banned short selling in 2015 during their stock market crash.

Examples of selling short

Let’s run two examples of a short selling scenario.

In both scenarios, our short investor wants to short TSLA. Let’s say the TSLA stock is at 800 USD. And the investor short sells 10 shares of TSLA for 8000 USD.

If TSLA goes down to 600 USD, our investor buys back 10 shares at 600 USD, for 6000 USD. So, our investor made 2000 USD of profit!

If TLSA goes up to 900 USD, our investor buys back 10 shares at 900 USD for 9000 USD. So, our investor made 3000 USD of loss!

We can see that this is basically the contrary of a long position.

Advantages of short selling

The main advantage and the main idea of short selling are to gain money when the market goes down. This is a good way to profit from the stock market going down. Normally, when the stock market goes, investors with long positions are losing money. But investors with short positions may win money.

The second advantage is the ability to use margin. We can basically make money with borrowed money. This allows an investor to multiply profits. Using margin (or leverage) is a great way to multiply profits.

Risks of short selling

Now, there are also some big risks or disadvantages to short selling.

The biggest risk is that your losses are not limited. You can lose an unlimited amount of money! With a long position, you cannot lose more than the value of your stocks. But with a short position, you can lose several times the value of your stocks. For instance, if you short a stock worth 1 USD and have to buy it back at 9 USD, you have lost 8 USD per share, 8 times more than the share’s original value! You can lose a ton of money if it goes wrong.

The other risk is that you may be forced to liquidate your stocks. If you do not meet your margin requirements, your broker will do a margin call. In this case, you will have to inject more money into your account. If you can not, the broker may liquidate your shares.

While you hold the borrowed shares, you have to pay interest on the loan. So, if you keep the shares for a long time, you may have to pay hefty fees on that.

And there something important with the interest rate: if there are few shares to borrow, the interest rate can go up. And in extreme cases, the interest may go very high, like a 25% interest rate on the loan. But it can go even higher. So, this can greatly impact your profits.

Finally, if there is a dividend issued while you borrow shares, you will have to pay this dividend to the broker. This is once again a sign that shorting a stock is generally not made for a long time.

As you can see, there are some significant risks to short selling.

Conclusion

As you can see, short selling is not a very difficult concept. It consists of borrowing shares, selling them now, and buying them back later on. By doing this, you can get profits when the stock market is going down.

This article is not meant as a guide on how to short stocks. This is only an introduction to short selling. If you want to short sell, I encourage you to learn more on the subject. This is not a strategy for beginner investors.

I have never had any short positions, and I do not intend to start. It is too risky for me, and I prefer to hold long positions for long-term investing.

Now, I still believe this is an interesting subject. And if you are interested in advanced investing stock market investing techniques, it is good to know about short selling. So, I hope this was interesting to learn about!

In this article, we have talked about the standard way of going short by selling an actual share that we have borrowed. But there are other more sophisticated ways to go short, for instance, with futures or options.

Now that we talked about short selling, would you be interested in an entire article on the Gamestop saga?

Full story here Are you the author?
Mr. The Poor Swiss
Mr. The Poor Swiss is the author behind thepoorswiss.com. In 2017, he realized that he was falling into the trap of lifestyle inflation. He decided to cut on his expenses and increase his income. This blog is relating his story and findings. In 2019, he is saving more than 50% of his income. He made it a goal to reach Financial Independence. You can send Mr. The Poor Swiss a message here.
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