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Everything You Need to Know About Short Selling

Trading, in itself, is a risky trade; short selling being riskier. Unlike traditional trading, the profit potential of short selling is limited and the risk potential is unlimited. Therefore, it is highly critical for a trader to need to know about short selling.

In the traditional forms of trading, the trader buys or sells the securities that he already owns. However, in some cases, a trader borrows the securities like stocks and sells the borrowed securities. This process is called short selling. Short selling is the practice in which the trader or the investor sells the shares that he does not currently own. The securities are borrowed from a broker and then sold, hoping that the prices of the shares will go down, so that when the prices go down the investor can buy them at lower prices and return them to the lender. In this process, the investor is able to make profits in the bear market due to the difference in the low buying price and the high selling price. Here is everything you need to know about short selling.

What is short selling used for?

There are mainly two purposes for which short selling is used by the traders:

  • Hedging of risks: An important reason for short selling is to hedge the risks. The trader may already hold a long position on the same or related securities and has the risk of the market taking a downward turn. In this case, the trader hedges his position by short selling the same number of shares on the same securities. The shares sold short protect the short sellers against the risk of the prices going down.
  • Speculation: Another major purpose of selling a stock short is speculation. An investor may anticipate the price of a security to go down because of an impending financial disclosure or other factors. At this time, the investor borrows the shares from the brokers or financial advisors and sells them short at a high price. Later, when the price goes down, he buys the same number of shares and returns them to the lender. This results in profit because of the price difference between the sold shares and bought shares.

Requirement of a Margin Account

It is required for the trader to have a margin account in order to be able to short sell the shares. This is regulated under the Regulation T of the Federal Reserve Board, due to the inherent nature and riskiness of the short selling transactions.

Under the Regulation T, it is mandatory for a trader to hold a margin account with 150 percent of the position value. The 150 percent includes 100 percent as the full value of the short position, and an additional 50 percent as the additional margin requirement. The reason is that the trader is actually selling something that he does not currently own. Therefore, to secure the positions and protect against the risk of position going against the trader, margin money is needed in the account.

If the price of the short sold security starts going up, against the expectations, the broker can raise a margin call and take the additional money. Also, if the broker wants to liquidate the position when the value of the short position diminishes due to price rise, a margin account is required.

Regulations on Short Selling

We have understood that short selling is a complex and risky process, which may result in infinite losses. Also, short selling can put a lot of pressure on the market when a lot of short sellers decide to short sell the shares of a particular company. The share prices of the company can go down drastically and inorganically, and the entire stock market can get destabilized. For these reasons, short selling needs to be highly regulated.

The SEC has put many restrictions and regulations on selling the shares short. The most significant rule is the uptick rule, which states that short selling is allowed only at a higher price or uptick from the stock’s most recent sale. This rule prevents unnecessary pressure on the market and keeps it in balance. Also, if the price of a security has fallen by ten percent over the closing price of the previous day, the security cannot be sold short. This is done to prevent the pressure on the security, forcing its prices further down.

Another critical rule for short selling is that the shares must be available with the trader before he sells them. Naked short selling, that is, selling the shares without borrowing them, signifies no intent on behalf of the trader to deliver them if required. Therefore, naked short selling is illegal and short selling can only be applied to the shares available. The trader must furnish proofs of borrowing the shares and must be able to honor his obligation to deliver the shares, if required, at the time of settlement.

Advantages of Short Selling

Short selling helps in the price correction of the stocks that were overvalued. It provides the ability to the traders to make profits even in the bearish market. Short selling also gives the much-required liquidity to the market. The process has profit potential due to the price difference between the sold and bought shares. Short positions can also be taken at a margin payment.

Disadvantages of Short Selling

The risk potential of short selling is unlimited and could become one of the most terrible mistakes people make when investing. If the price of the short sold security goes up, the trader will bear infinite losses. Short selling also makes the market more volatile and may lead to destabilization of the entire stock market, which can mean irreparable losses if you don't know the ways investors deal with volatility. It can also cause the price of a company’s stock to roll down drastically, if a lot of investors start short selling the shares of the company. The unregulated and illegal forms of short selling can cause more harm than good and can be used for manipulation and fraud.

The Bottom Line…

A layman would ask that if short selling is so risky, why should one go for it? Why wouldn't every trader just enjoy the benefits of long-term investment? Well, along with the high risks involved, short selling is an excellent mechanism of making money even when the prices of the securities are going down. It can be used to hedge funds and protect against downside risks, along with speculating on the downward movement to make profits. But, of course, the traders need to know about short selling before dipping their toes in it. It is better to be well-informed than regret later!

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