What is Short Selling?
Generally, the purpose of buying a stock is to profit from price appreciation. This involves buying a stock long and selling the stock at a higher price to pocket a profit. The profit is generated from rising stock prices. On the flip-side, short selling allows traders to profit from falling stock prices. This is done by short selling the stock and buying it back, also known as ‘covering’ at a lower price. The mechanics of short selling involves borrowing the shares through your broker to sell, then covering the shares by buying it back (hopefully) at a lower price. The broker then returns the shares back to clearing firm.
Note: Short selling requires a margin account.
Benefits of Short Selling
Ability to Play Both Sides
The most obvious benefit of short selling is the ability to profit from falling stock prices. This is most useful when broad markets are falling and especially in bear markets. This gives the trader the flexibility to play both sides of the market, long and short. Who better knows how weak a stock is than someone stuck in a long position? With the ability to short, the same trader has the ability to reverse his long position into a short position and profit from the weakness.
Hedging Long Positions and Portfolios
Additionally, shorting is also a means of hedging long positions. Many traders will look to hedge a long position with a short position in a peer stock or index. For example, a trader may be worried about his long position in one company and opt to hedge with a short position in a competing company in the sector.
1. Understanding Borrows
In order to short a stock, the shares must first be borrowed. These shares are borrowed from the clearing firm that the broker clears through. Since the clearing firm technically holds all the stock certificates, it is able to seamlessly and electronically loan out shares when they are available.
The borrowing of shares may seem complicated, but it is all done electronically and seamlessly through the broker. When there are shares available to borrow, then traders are free to short sell them.
Easy Versus Hard Borrows
The inventory of available short shares for a particular stock will determine if it will be an easy or a hard to borrow. Widely traded stocks with large float like large cap blue chip stocks will have an excess inventory of available shorts making them very easy to borrow and short-sell instantly.
Thinner traded stocks with smaller floats may be hard to borrow, especially if there is news that is triggering large volume activity. Your online broker should have a list of short-able stocks and available shares either posted throughout the day or at the ready. Hard borrows may incur larger margin interest as well, depending on the situation. It’s very important to be aware that some of the larger short squeezes are on stocks that are hard borrows because the inventory of shorts keep running out, thereby trapping the short-sellers until they face forced liquidations which can further propel the shares higher.
2. Understanding Locates
When shares are hard (to) borrow, you can call the broker to locate shares ahead of time. The direct access brokers tend to have an option to “Locate” short shares for stocks. This may take some time and may incur an additional fee. However, if you are very familiar with the underlying stock and how it trades, it may be beneficial to locate the shares ahead of time. By locating, the broker will check with various clearing firms to seek out availability and reserve the shares. The broker may even outsource the locate request to specific locating services to find the shares. This is all done behind the scenes.
Reserve Your Shares in the Morning
You will have to specify how many shares you want to reserve. There is no obligation to use up your total reserve of short shares, but if you do short-sell them, then you may incur a fee, higher margin interest and higher maintenance margin. The higher maintenance margin may require you to have 50% to 100% of the capital thereby cutting your margin from 4 to 1 to 2 to 1 or even 1 to 1. This is extremely important to be aware of. When maintenance margin rises, it causes many traders to unknowingly get stopped out by the broker due to intra-day margin calls and forced liquidation. This is another reason why short squeezes can be drastic on thinner trading stocks.
It’s always prudent to reserve your shares pre-market to have them at the ready in case an opportunity to short-sell arises. This should be done just after your finish putting together your watch list. As the cliché goes “It’s better to have a gun, than need one and not have it”.
3. Getting the Proper Broker
There are many factors to consider when selecting an online broker. The availability of shorts and hard to borrow shares are very real factors to consider. The larger the inventory of available shorts, the more appealing a broker will be. Shorting allows you to play both sides of the market, thereby giving you twice the opportunities to profit on a particular stock.
4. The Short-Sale Rule
The short-sale rule is a restriction that requires short selling to only be performed on an uptick. This is also known as the uptick or plus tick rule. The rule had been in place since 1938 to avoid bear raids and manipulation in the markets. It has since been modified to apply to stocks that are trading down 10% or more from the previous trading day. This means short sales must be filled at the inside ask/offer. The restriction lasts until the end of the trading session. Check with your broker on their procedure for enacting Rule 10a-1(a)(1).
5. Margin Calls
Margin calls trigger when your account equity falls under the maintenance margin requirement for any specific position. Depositing more capital into the account or scaling down the position can satisfy the margin call. Each brokerage has their own thresholds and procedures for implementing margin calls. It is important to be aware of the maintenance margin required for any position you plan to hold. Be aware if the stock has any special restrictions or margin changes.
Many online brokers will implement a forced liquidation to satisfy intra-day margin calls. It’s prudent to pay attention to any alerts on your platform in case this happens. Forced liquidations can wreck havoc on your trading account, as the ramifications can be swift. Therefore, it’s important never to go “all-in” on a short position or any position for that matter.
6. Short Interest
The short interest for a particular stock is reported as a percentage of the float, which is reported monthly. Every stock has a short interest that stems from shares being borrowed by market makers to hedge funds. The purpose of the borrowed share can range from hedging to bearish bets on the underlying company. When the short interest starts to grow above the 20% mark, the possibility of a short squeeze tends to rise. Stocks with high short interest are susceptible to explosive short squeezes.
7. Short Squeezes
A short squeeze is a market phenomenon where share prices rise rapidly on heavy volume fueled by massive buying pressure stemming from short covering. Stocks with high short interest and thin floats tend to squeeze the most. The availability of short shares also tends to evaporate, which traps short-sellers as they desperately try to cover positions as losses compound rapidly.
Tips To Avoid Getting Squeezed
The best way to avoid short squeezes is to be aware of the availability of shorts for a particular stock. If the short inventory is under 100,000 shares, then best to stay away. Squeezes tend to form by blasting higher at exhaustion levels, thereby sucking in more short-sellers anticipating a reversion that doesn’t happen in the near-term. Pay attention to the trend and take stop-losses prudently. Most importantly, be very careful with adding to a losing short position. Most of the times, it’s better just to take the stop and re-enter when the smoke clears.