Short Selling: What Exactly Is It and Why Investors Do It

What Is Short Selling?

Most investors have a long-term perspective and purchase stocks — or go “long”— as we say on the Street, with the expectation that the stock price will rise. Conversely, others go “short,” anticipating the price of specific stocks will go down.

Greater Risk

Going short can carry more risk than going long. While there is an unlimited upside to a stock’s price (theoretically), the downside is limited because the share price cannot go below zero. Depending on the strategy you employ when establishing your short position, you can lose more than your initial capital.

Shorting A Stock By Selling Shares You Don’t Own

The stock of Consolidated Widget is selling for $100 a share which your analysis informs you is far above a rational market price. Although you don’t own shares in the company, you execute a short sale. To open your position, your brokerage firm borrows the number of shares you are shorting (selling without owning the shares) and establishes the amount of money you must keep in your account to meet their margin requirement for this transaction. To close out or cover your position, you purchase the number of shares you sold and your brokerage firm returns them to the account that loaned them to you.  Any profit or loss is captured when you close your position.

Shorting A Stock By Purchasing Buy Put Options

There are two types of equity options: puts and calls, which you can trade on most listed stocks. If you buy a call, you believe the price of the stock will go up. If you buy a put, you believe the price of the stock will go down. A put is a contract that gives the buyer the right to sell that stock for a specific price, known as the strike price, at a specific time in the future, known as the expiration date.

The Details Of Buying A Put

The price you pay for the put is called the put option’s premium. If the stock price goes below the put option’s strike price, plus the premium you paid to buy the put, you make money. You lose money if the strike price does not decline between the time you bought the put and the time the put expires. Your loss will be the premium you paid to buy the put, even if the stock price goes through the ceiling. Buying a put exposes you to less risk compared to selling the stock short.

Hedging an Equity Position by Shorting

Institutions, traders, and hedge funds will use different shorting strategies to protect an equity position they hold from a potential price decline.  On the Street, this is a classic “hedge” position, where puts are used like an insurance policy against the stock dropping in value.  If the stock price does go down, the value of the short trades they executed will go up and offset the price decline of their stock. For a full explanation of how put options work and can be used, visit the Chicago Board of Options Exchange website here.

Many investors only buy or sell options and never buy or sell the underlying stocks.  Like the commodities and equity markets, the options market has a significant amount of program trading.  This means computers are doing the buying and selling according to sophisticated mathematical models. So, a retail investor is up against stiff competition, and about 75% of all options expire worthless. [1] Keep in mind, in the options market, for every put you buy, expecting a stock’s price to decline, someone is selling you the put equally convinced it won’t.

Trading options is of great interest to many people, and the number of retail options trades have exploded since the Covid-19 pandemic began. But like every other way to trade securities, risk always lurks in the background. [2]

Resources:

[1] money.usnews.com/investing/articles/2017-01-12/are-stock-options-worth-the-effort

[2] investmentnews.com/retail-investors-flocking-to-one-of-the-all-time-suckers-bets

Contributing Writer: Subject Matter Expert Charles McCain