To short a stock, you have to borrow the stock first. This requires calling your broker or discount phone line. The stock can be borrowed from other investors or from the firms account. Your advisor or discount representative will find the stock. There is an interest charge applied while you are borrowing the stock that is paid to the firm.
In most jurisdictions, you can only short a stock after it has traded higher on the previous trade. This is to help avoid having large investors start shorting stocks into a free fall and to make it harder to short stocks in a downtrend or big sell off day.
Shorting stocks is the opposite of buying a stock, or shares, in a company. When an investor short sells a stock, they borrow shares from their broker’s account or their broker borrows shares from another investor, and then the short seller sells the shares with the expectation the stock price will decline – at which point the shares will be bought back. Essentially, the investor is selling shares they do not own with the intention of buying the back at a lower price and keeping the difference between the sale and purchase price.
A short position can be created without selling a stock short by purchasing an exchange traded fund that has the mandate to be short stocks or trade inversely to an index or sector. There are a number of ETFs that perform this task and one can search for a list at the websites of the major ETF providers, like iShares, Vanguard or Horizon Investment Management, among others.
An investor can create a synthetic short position using put options. An investor would purchase an Out Of The Money put or At The Money put. This gives the purchaser of the option the right sell the stock at the strike price should the share price decline below the strike price. The break-even price for this type of trade is calculated by subtracting the premium from the strike price. The max loss is the cost of the premium to purchase the put option.
This process creates a different risk profile than buying (being long) a stock. In the case of being long a stock, the maximum risk is 100% of the investment, in the case the stock goes to zero. But the maximum return is theoretically unlimited, as in theory, a stock price can trade to infinity. With short selling this risk profile is reversed, where the maximum gain is potentially 100% of the investment if the stock were to drop to zero, and the maximum risk unlimited should the price rise to the theoretical level of infinity. For this reason, being short a stock is a higher risk position than being long, and adequate risk management techniques should be incorporated, such as employing a stop loss order (an order to sell a stock should it rise through or drop through a specified price) to avoid large losses.
Another risk an investor needs to know about when short a stock is that if that corporation pays a dividend, the participant who is short the stock must pay the investor who lent the stock the dividend. This means the investor short a stock can lose money even if the price of the stock is unchanged.
A final common risk is that your short position could be called away before you are able to make a decent return. If the lender of the shares decides to put those shares up for sale, the investor who is short the stock must return the shares to the lender regardless of price. This requires purchasing the stock in the open market. Often when a stock begins to decline or is overpriced, the gain is limited due to the original owner wanting to sell the shares. If the investor who is short wants to continue to be short, they would have to find another investor willing to lend the shares and this may create multiple transactions to complete a single short trade objective.
The following charts give a visual representation on the differences between the two strategies. Shorting a stock carries more risk of large loss but a higher potential return, where the synthetic short has a lower profit potential but also a smaller maximum loss.
Feb 5 / Posted by Brad Parkes
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Jan 18 / Posted by Brad Parkes