Short-Selling Explained - Lightspeed

Introduction

In the mercurial world of finance, investors can take advantage of both rises and declines in the market. Taking a short position can be a powerful tool in the investment repertoire because it allows investors to benefit from falling markets. Here, we will explore the components of this investment strategy, outline its benefits and drawbacks, and discuss points that should be considered prior to trading.

What is a Short Position?

A short position is a trading strategy where the investor sells borrowed stock to attempt to buy back later at a lower price. The expectation is that the stock price will fall after the initial sale, allowing the investor to profit from the change. For example, if the investor borrows 10 shares from the brokerage, sells them at $100 per share, and then the price of the stock falls to $50 per share, the investor can repurchase the 10 shares at the lower price. The profit is the difference between the $100 sale and the $50 purchase (minus commissions and fees). A margin account is needed to complete this type of investment strategy because it allows you to borrow from the brokerage. You must also meet the brokerage’s maintenance margin requirement on borrowed stocks.

Benefits and Drawbacks of a Short Strategy

Benefits

Potential Profits From a Downward Trend: Traders can potentially profit from the downward turn of a stock. This allows investors to diversify their trading strategies by taking advantage of rising and falling markets.

Borrowing Ability: Uses the firm’s resources to borrow unowned shares to implement the strategy.

Hedging: Protects other investments by diversifying the investment strategy. For example, taking a short position in a broad-based ETF such as SPY can help offset losses on individual stocks within the S&P 500.

Drawbacks

Unlimited Losses: Short positions can be risky because there are limited gains but potentially unlimited losses. This is because profits are limited to a stock’s distance to zero. If you short 100 shares at $10, they would have a market value of $1000. If the stock price decreases to zero, your maximum profit would be $1000. Conversely, a stock could rise infinitely and so could the potential for loss.

Stock buy-in: A stock buy-in is where the brokerage requires the position to be repurchased if it can no longer be borrowed. This forced closure can impact your portfolio negatively due to the potential for loss on the short position should there be a required repurchase.

Short Squeeze: A short squeeze is where a shorted stock increases in price as traders must buy it to cover their positions. This can result in an immediate rise in the stock price if enough traders are forced to buy back the stock simultaneously.

Fees: Short positions are also associated with fees to enter and/or carry them overnight. For instance, some stocks are marked “locate required”. To enter a short position on these symbols, you must first locate the stock, which requires you to pay a fee. These fees can fluctuate depending on float, price action, and the brokerage firm in which you trade or invest at. There is also the fee of margin interest if you choose to carry your short position overnight. It is important to note that that locate fees can be assessed on subsequent trade dates than the initial day the locate was purchased.

Margin Call: There is a possibility that you can be issued a margin call by your brokerage firm should a shorted stock in your portfolio increase in price to a point that a margin call is triggered.

Dividend Payout: Keep in mind that even if you are shorting a stock, you are still responsible for the dividend paid out on that particular symbol to the lender. As the short-seller, you are not entitled to the dividend payout.

Important Considerations

Close Monitoring: The investor must closely monitor the stock and the market when short selling to pinpoint declines.

Understand Risks: Short selling is a high-risk strategy used on both short-term and long-term investments. However, it may not be appropriate for investors who seek a more long-term approach.

Exit Strategy: Investors should have an exit strategy in place when short selling because of the risk factors involved.

Conclusion

Short selling can provide a way to profit from a falling stock or market. However, because it is high-risk, it’s important to consider whether short selling is the appropriate strategy for your financial objectives.

*Please consider all possible risks and review disclosures to determine which account is most suitable.