In “The Big Short”, hedge fund managers Michael Burry and Steve Eisman correctly predicted the collapse of the US housing market and used investment vehicles called credit default swaps in order to bet against mortgage-backed securities.
This bet is the aforementioned “Big Short” – an investment that makes money when the price of a security declines. Most investors buy stocks of companies they believe in, hoping to make money off their future profits.
Short sellers do the opposite, borrowing shares to bet against companies they believe will tumble. But short selling isn’t this cut and dry compared to buying – especially when it comes to the risks.
Intro to Shorting Stocks
Usually, shorting a stock goes like this: you identify an overvalued security and wish to take an opposite position. To do this, you don’t buy the stock outright, you borrow the stock from your broker and immediately sell it.
You eventually need to return the shares to your broker, but you anticipate the share price being much lower when it comes time to settle up (which is called covering your short).
If the stock you borrowed declines 10%, you can buy the shares on the open market and return them to your broker. You’ve now made a 10% profit on the trade – the difference in the price you sold the borrowed shares for and what you paid when returning them to your broker.
Shorting stocks requires a margin account since you need your broker to lend you the shares in the first place. Borrowing shares from your broker involves the same stipulations as borrowing cash, including interest payments.
(Note: You can also bet on a stock to decline by buying put options. A put option is an agreement to sell a particular security at a predetermined price on or before a specific date. Options don’t require a margin account, but they do involve leverage so be sure to understand how they work before attempting to short a stock in this fashion.)
Steps to Short Selling a Stock
Here are the basic steps for shorting a stock:
- Check to see if there are shares available to borrow (usually a stock will be marked if it is hard to borrow – HTB – but is different for each broker).
- Place a sell order on the stock you want to short.
- Buy back the shares at a lower price for a profit or at a higher price for a loss.
With LightSpeed, they have a couple symbols for stock inventory. The pic below shows in the top right corner a red “T”, this indicates there is no inventory and the stock cannot be shorted.
In the pic below you will see a grey “L” in the top right corner. This means you need to request a locate with your broker to see if there are shares available. Sometimes you will have to a pay fee to borrow the shares, especially if they are hard-to-borrow.
Keep in mind that this can be different from broker to broker so make sure to reach out to their customer service to gain a complete understanding of how they shorting process works.
Important Note – shorting stocks can ONLY be down in a margin account and if you hold a short position overnight you will be charged interest based on the amount you are borrowing. If you day trade it, you will not be charged interest.
Why It’s Important to Be Able to Short Stocks
To many investors (and some electric car CEOs), short sellers are just the worst. They push down stock prices and profit off the misery of others. But short sellers do serve a few important purposes.
For starters, they have a tendency to root out fraud and misconduct – a sentiment Warren Buffett admitted to sharing in a 2006 Berkshire Hathaway shareholders meeting.
Additionally, short sellers provide demand for shares and enhance market liquidity. Buffett had no issues with investors who sold Berkshire Hathaway short since they eventually had to buy the shares to cover.
When shorts misfire, they have to buy back the stock quickly in order to prevent deeper losses. Since stock prices don’t have ceilings, losses from short sales can exceed the initial cost of the investment.
When short sellers scramble to cover, it creates a cycle where more short sellers are forced to cover to prevent massive losses – this is called a ‘short squeeze’. Short squeezes cause stock prices to rise rapidly as the market for sellers dries up and upward pressure multiplies.
Pros and Cons of Short Selling
Now that we’ve established that short sellers aren’t evil incarnate, let’s talk about benefits and drawbacks.
Short selling involves more risk than traditional stock trading and successful traders use it as part of a larger overall strategy instead of a way of life.
Pro: Short sellers flock to frauds
Short selling growing and profitable companies makes very little financial sense. Short sellers by definition are looking for weaker stocks with shaky balance sheets, faulty products, or questionable decision-makers.
Sometimes they even find a combination of all three! By looking for stocks with elevated short interest, you might be able to find companies headed for a downturn.
Con: Potentially unlimited losses
When buying a stock, your maximum loss is the initial amount you invested – you can’t go below zero. But that’s not true for short selling. When you sell short, you’re borrowing shares and immediately selling them.
Then you wait for the decline before returning them to your broker. But what if the stock soars on news of being acquired and the share price doubles? Short sellers run the risk of losing more than they initially invest if the stock takes the elevator up instead of down.
Pro: Easier to hedge your portfolio
One of the most common uses of short selling is hedging a long portfolio in case stocks enter a bear market. Short sales are often used as “insurance” against market declines since the gains of the short will offset the losses of the portfolio.
Many traders also hedge stock purchases with put options to protect against downside risk.
Con: Bull markets are more common than bear markets
Short selling might sound exciting and glamorous, but it’s a money-losing move in most markets. The simple fact is that bull markets usually stick around longer than bear markets and shorts will inevitably find themselves on the wrong side of a few trades.
Stocks go up more than they go down; otherwise what’s the point of all this?
Short Selling Example
Let’s say you want to invest in (and short) companies developing coronavirus treatments. You’ve got a good read on the biotech industry and you think Pfizer and Gilead will have success with their clinical trials, but Moderna and Inovio Pharmaceuticals will fail.
In this scenario, you’d buy 100 shares of Pfizer and Gilead and sell 100 shares of Moderna and Inovio short. There’s no minimum or maximum on how long short sellers must wait until covering, but they do need to maintain proper margin levels and pay interest to their broker.
Thankfully, these clinical trials are rapid fire – Moderna, Inovio, and Gilead all flop while Pfizer reports successful results. Moderna and Inovio shares tumble, so you can buy them back on the open market and return them to your broker for a profit.
You sell Gilead for a loss and hold Pfizer for the time being. This trade earns profits on both shorts, a loss on the Gilead investment, and unrealized gains on the Pfizer investment.
So, for example, if you sold short Moderna at $100 a share and bought them back at $90 that means you made $10 profit per share (minus commissions, exchange fees, etc.)
Short sellers sometimes get a bad reputation, but they have important roles to play. Shorts hammer companies with fraudulent numbers and provide liquidity to otherwise dry areas of the market.
But shorting stocks also comes with specific risks, including the loss of more than your principal. Short sellers are also swimming against the current in bull markets and often subject to vicious rallies in bear markets. Shorting is hard, make no mistake.
But when the market turns on a dime like it did when the coronavirus hit, shorting protects your long-term investments and creates plenty of profit opportunities in the short term.