Money can be made in equities markets without actually owning any shares of stock. The method is short selling, which involves borrowing stock you do not own, selling the borrowed stock, and then buying and returning the stock only if or when the price drops. The model may not be intuitive, but it does work. That said, it is not a strategy recommended for first-time or inexperienced investors. It's also a form of trading that can be abused, which is why regulators have put protections in place to guard the integrity of the market.
Key Takeaways
- Short selling involves borrowing stock you do not own, selling the borrowed stock, and then buying and returning the stock when the price drops.
- Because of the risky nature of short selling, certain regulations have been implemented to protect traders and the wider market, including an alternative to the so-called uptick rule put in place in 2010.
- Short selling is not recommended for novice investors.
- Short selling can only be done in a margin account with a broker. You must have 100% of the short sale proceeds plus another 50% of the short sale value in the margin account.
- The Financial Industry Regulatory Authority (FINRA) requires that you keep at least 25% of the total value of the equities in your account as maintenance margin at all times.
How Short Selling Works
Shorting must be done through a margin account you set up with a broker. While regulations about margin accounts vary, all require an initial minimum equity commitment, usually $5,000. That's just to open the account. If there's a stock you want to short, you must have 100% of the short sale proceeds plus another 50% of the short sale value in your account.
For example, if you short 100 shares of XYZ stock at $20, you would need to have the full value of that sale, $2,000 (100 times $20), plus an additional $1,000, in your margin account.
Additionally, the Financial Industry Regulatory Authority (FINRA) requires that you keep at least 25% of the total value of the equities in your account as maintenance margin at all times. Many brokerage firms require an even higher percentage to protect themselves and you from devastating losses.
Short Selling Example
To recap, the object of short selling is to sell a stock and then buy it back at a lower price. The profit is the difference between those two prices.
Suppose you believe Company XYZ's stock, selling at $35 a share, is going to drop in price. You take a short position on XYZ and borrow 1,000 shares of the stock at the current market rate. Five weeks later, XYZ stock falls to $25 per share, and you buy the stock. Before taking out any brokerage fees associated with the short, your profits are $10,000: ($35 - $25) x 1,000.
The rules for short selling are set by the Securities and Exchange Commission (SEC).
Short selling is risky because stock prices, in general, increase over time. In addition, theoretically, there is no limit to the amount a stock price can rise, and the more the stock price rises, the more will be lost on a short.
For example, suppose you take the same short on XYZ at $35, but the stock increases to about $45. If you covered this short, you would lose, before adding any brokerage fees, $10,000: ($35 - $45) x 1,000. Now consider how much you would lose if XYZ's stock price went up to $100 per share, or still higher.
Conversely, the profits possible from a short sale have a calculable limit. Suppose you take the same short with the same stock and price. After a few weeks, XYZ goes to $0 per share. The profit from the short would be $35,000 minus fees. This gain represents the maximum that you can make from this investment. As such, your potential profits are limited; your losses are not.
Short Selling Regulations
Critics say there are greater risks in short selling than just those to the investors who use the strategy. Short sales, they say, are a risk to the companies whose stock is shorted and, more widely, to the stability of the financial markets.
To address the potential risks and abuses of short selling, particularly its more speculative forms, the SEC has implemented several important sets of regulations. In 2005, the SEC enacted Regulation SHO, which prohibits naked short sales. Shorting is considered “naked” when the shares in question have not been affirmatively determined to exist. Regulation SHO introduced requirements for brokers to predetermine the existence of shares that can be shorted and “close out” failure to deliver positions.
The SEC had long had a regulation known as the uptick rule, which required short sales to be realized at a higher price than the previous trade. The initial regulation, known as Rule 10a-1, came into effect in 1938. However, the regulation was undone by the SEC in 2007, following a study by the SEC that concluded that the regulation didn't curb abusive behavior and could limit market liquidity. Three years later, the SEC approved a new, alternative rule. The updated uptick rule mandates that trading centers develop and enforce procedures to prevent the execution or display of short sales that are not permitted. The rule also triggers a circuit breaker if a stock's price has fallen 10% in a single day. When this happens, the alternative uptick rule gives priority to long position holders to sell their shares before more short sellers jump in and send the price spiraling even lower.
New short selling regulations came into effect in October 2023 specifying that investment managers whose short positions reach a certain threshold must report their shorting activity to the SEC. Also, the SEC requires companies that lend securities for short sales to disclose that information to FINRA.
How Does Short Selling Affect Market Volatility?
Short selling can increase market volatility, particularly if there's economic uncertainty or market decline. When many investors are short-selling, this can lead to a vast rise in selling pressure on the stock, driving its price down further. In some cases, this exacerbates market downturns. However, short selling can enable greater liquidity of the borrowed shares and help bring overvalued stock prices back to earth, helping to prevent bubbles and stabilizing the market in the long term.
What Are the Tax Implications of Short Selling?
The tax implications can be different than with traditional stock trading. Profits from short sales are typically treated as capital gains and are subject to capital gains tax. However, the holding period for determining whether the gain is long-term or short-term is calculated differently. For short sales, the holding period begins when the short position is covered (not initiated). Thus, even if you hold a short position for over a year, the gain may still be treated as a short-term gain, which is taxed at a higher rate. In addition, if the short involves a stock that pays dividends, the short seller must pay any dividends owed during the short sale period, which then has tax implications. As always, it's best to consult with a tax professional to understand the tax ramifications for the shorts you're considering.
How Do You Borrow Stock to Sell Short?
To borrow stock to sell short you must first open a margin account with a broker. The account needs to be funded by the legally required amount. Once you place the short sale order with your broker, your broker will borrow the shares, either from their own portfolio or from other sources, such as another client or another broker. Once the broker has the shares in hand, they will sell the shares and deposit the funds in your account.
What Is a Short Squeeze in Short Sales?
A “short squeeze” occurs when a heavily shorted stock’s price starts rising rapidly. This increase can result from positive news, a good earnings report, or something else that changed investor sentiment on the stock. Whatever the reason, it’s not good news for anyone shorting the stock. Having bet on the stock price falling, they might have to buy back shares quickly to close their positions and cut their losses, especially if they are facing margin calls. That’s bad enough, but the rush to buy back the shares before the stock price goes higher can drive it up even further. Thus, during a short squeeze, short sellers compete to buy up the limited number of available shares, causing a rapid surge in the stock’s price. At this point, the losses for those squeezed out can be substantial.
The Bottom Line
Short selling is a sophisticated investing technique best left to experienced investors with well-honed market skills and a fairly strong risk tolerance. While the potential gains can be tremendous, they are limited, while the losses are not.
