What is Short Selling?
Short selling is a trading strategy where a trader can borrow shares from their broker to sell at a set price in anticipation of that stock price dropping, then buying them back at a that lower price creating a profit. It is still buying low and selling high but in reverse order.
Short selling creates profit when the price of stock or security goes down. You can also lose money if the price of the stock goes up. The risk is that stock prices can theoretically rise indefinitely, but a stock price can only go down to 0. The process of repurchasing the stock to close your short position is known as “covering” or your broker’s order screen might say Cover or Buy to Cover.
The History of Short Selling
Short selling has been around since the 1600’s and it has always had good and bad opinions even from the beginning. In various examples throughout history, it has been labeled as a primary reason in large market declines. Jacob Little, known as “The Great Bear of Wall Street”, was famous for shorting stocks in the United States in the early to mid 1800’s. Short sellers like the great Jessie Livermore were blamed for the crash of 1929. Federal regulations regarding short selling were implemented in 1929 and again in 1940.
In 1929, Congress enacted a law banning short selling during a downtick, which was to become known at the “uptick rule,” and was active until 2007. This means that a short sale order can only be filled after someone bought that same stock and their order caused an uptick when purchased at the Ask price. Some people believe that the uptick rule prevent stocks from dropping so fast and others believe the stocks would have gone down anyhow. Another popular use of short selling is to hedge market risk by using a combination of owning shares, using various stock option strategies and shorting the stock at the same time. This is the basic concept behind hedge funds.
Short Selling Risks
As said before, the greatest risk of selling short compared to buying stock (going long), is that the price of the stock can go up indefinitely, but it can only go down to 0. Meaning that if you sold short 100 shares of XYZ at $30 per share for a total investment of $3000, the max you could profit on this trade would be $3000 assuming the stock goes to zero. But stock XYZ could potentially go up to $300 or higher and your loss could far exceed the $3000 max profit from shorting. It is for that reason, that short selling is primarily used as a hedge tool.
As a short seller, you must also be alert to the risk of a short squeeze. When a stock price goes up, some investors who have shorted the stock will begin to cover their positions to limit their losses. Others may be required to close their positions to meet margin calls or to meet other terms with their broker. Since all of this covering requires these people to become buyers, the short squeeze causes an even larger increase in the stock’s price. The end result is a huge upswing in a stock’s price and larger losses for those still shorting the stock.
Finally, as a short seller, you should remember that you are trading against the overall upward trend of the markets. Combined with the other risks, it makes more sense to be open in short positions for a shorter period of time compared to being long.