Most investors buy a stock because they expect the stock to perform well. Have you ever considered buying shares in a company you expect to perform badly? Short sellers make money every day selling short companies they do not like, instead of going long (buying) shares in companies they like. Also called speculators, short sellers speculate on the future price of a stock. If their bet is right and the stock price falls, they make a profit.
Short sellers help create liquidity in stocks, which require demand by both buyers and sellers. If you go long a stock, you are buying it in anticipation of an increase in price on an undervalued stock. If you go short a stock, you expect the price to fall on an overvalued stock. The concept of ownership, however, is different when you short a stock. When you buy a stock, you take legal title of it. When you short a stock, you borrow the stock.
Let’s look at an example. James Chanos is a famous short seller who is in the news this week advising investors to short Tesla Motors – the maker of the electric car with the sexy design popular with the upwardly mobile. If you take his advice, you will call up your broker and borrow, let’s say 10 Tesla shares at $200 a share, or $2000.
One month later, Tesla’s stock price drops to $150 and you decide to buy the shares back from your broker for $1500, plus brokerage commission. You have made $400 and change. If the price per share goes up to $250, on the other hand, you are facing a loss of $250, plus brokerage fees.
There are five basic steps to shorting the stock.
- Research the Stock
If you short a stock, your investment should be based on strong fundamental research. Good short sellers conduct thorough research. They are often experts in certain industries, which allow them to identify short-selling opportunities. You may forecast that sales will decline due to economic conditions, or new competition will decrease demand for a top-selling product.
Some short sellers have been accused of being unscrupulous and creating rumours to make the price of a stock fall. While short selling is legal, short selling and starting rumours to manipulate a stock price is illegal and could land you in prison. Short sellers have also faced criminal charges for cooking the books and insider trading.
- Set Up a Margin Account
Most basic online trading accounts will allow you to trade on margin, that is borrowing money from your broker to buy stock. You will be required to set up a margin account, separate from your cash account. Typically, a deposit is required, which will serve as the minimum margin and allow you to borrow up to 50% of the price of a stock.
A margin account allows you to trade in excess of the assets in your account by leveraging those assets as collateral. With a $2000 initial margin, you may be able to buy as much as $4000 in Tesla stock. Like any loan, you will pay interest on the amount borrowed. For this reason, margin accounts are typically used for short-term trading. The benefit is you can increase the amount of stock you own, and thus your returns if the price moves in your favour. The risk is that if the stock price moves against your position, you could lose your loss will be greater. If your loss exceeds your collateral, you will receive a margin call expecting you to deposit money to cover the losses.
- Borrow the Shares
Borrow 10 shares of Tesla from your broker. Most online trading accounts have automated the process and will provide you with the option to borrow shares. Your potential losses will be limited by the amount you borrow. If the price rises, you may have the option to post additional collateral. If you do not cover the position, the broker will sell the shares to cover the losses.
- Sell the Shares
Immediately sell the shares on the market for $200 a share and the $2000 will be credited to your account. This action will actually be performed automatically when you enter into a short position and appear seamless to the investor.
- Repurchase the Shares
The price of Tesla shares has fallen to $150. You will buy the 10 shares in the market at $150 and return them to the broker. This is called covering your short position. The difference in your account is your profit – $500 minus the interest paid. What if the price rises? Short sellers also use stop orders to minimize potential losses by selling the shares should they reach a certain predetermined price.
Speculating vs Hedging
Remember, speculators are risk takers, and sometimes called gamblers because they do not own the underlying assets they are investing in. Tesla, for example, buys batteries to run electric cars. Let’s say it has bought 2 million worth of batteries at X price. Tesla also could sell short 2 million batteries at X price to hedge against the potential loss from a change in battery prices. James Chanos shorts the same batteries for X price. What is the difference between the two trades? Tesla owns the underlying assets. Tesla is a risk manager, or hedger, whereas Chains is a risk taker or speculator.
Beware of the Short Squeeze
Before you enter into a short position, check the short interest and volatility of a stock. The short interest – or number of shares being shorted by investors – is publicly available information. If other investors are shorting the stock, this may be a sign that they have come to the same conclusion as you, but not necessarily. Some shorts may be trading on rumours that end up to be false. Let’s say you are all wrong and the stock price begins to rise. As investors who have gone short start buying the stock to cover their position, the stock will move even higher. As the stock price rises, your loss will widen.
You, my friend, are in the middle of a short squeeze. Market manipulators may intentionally cause a short squeeze. In the early days of the Chicago Board of Trade, egg suppliers would corner the market in eggs by buying up all the eggs in order to cause prices to rise. Volatile stocks with high short interest are at a higher risk of a short squeeze. Also stay away from illiquid stocks.
Short selling has been behind spectacular gains and spectacular losses in the stock markets since the 17th century. By following the above steps, short selling can be done prudently and risk minimized.
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