Shorting is perhaps one of the most contentious and risky methods of profiting off price fluctuations. Perhaps the most notable shorter in history is Michael Burry, who shorted the US housing market before the Great Recession with substantial success while others experienced financial ruin. But what exactly is a short sale? And is it a practical investment strategy?
When you buy a stock or other security, you pay cash now for that asset and hope for it to appreciate in the future. Doing so assumes that the investment in question will go up in value. Once the holding sells, you receive cash for the security; the difference between this and your purchase price is the profit.
With short sales, this process works in reverse.
When you short sell, you go to market and sell a product you have yet to acquire. Then you wait, hoping that the asset will decrease in value.
If the security drops in value, you buy the asset to complete the transaction. The result is a profit equal to the difference between the sale and acquisition prices.
However, if the asset increases in value, you could lose an infinite sum until acquiring the underlying holding. Resultantly, short sales require substantial risk-taking, not for the faint of heart.
Requirements for shorting
Short selling requires an individual to have the following instruments:
- After-tax brokerage account w/ margin approval
- Proper margin account funding
- Asset availability
The first requirement of short selling is an after-tax brokerage account authorized for margin trading. For those new to margin trading, it entails trading with a mixture of deposited and borrowed funds. I will write a post on margin trading soon, which I will link once completed.
IRAs and other retirement accounts cannot utilize short-selling strategies since the Government imposes an annual contribution limitation on them, which could prohibit an investor from adding additional funds if a margin call occurs. Further, the IRS prohibits these investor funds from being used as collateral.
The second requirement entails having adequate funds in your brokerage account for margin trading. All short selling utilizes margin since an investor borrows securities to sell that they do not have; I will explain this further soon.
Margin accounts require an investor to maintain a certain funding threshold. The short-selling rules require an initial account holder to deposit 50% of the desired short sale present stock value in the account before opening a position.
Regulators impose a minimum account equity balance of 30% of the market value of the loaned short sold securities. Equity refers to the present value of the initial deposit after accounting for any unrealized profits or losses incurred from the short position.
Brokerage firms can require more than the 30% threshold to hedge against the risk they take on lending to individuals. Failure to maintain this minimum will result in a margin call for the account owner.
Further, if the investment in question is under $5/share, 100% of the present market value of the security or $5/share is required to short, whichever is greater; this is because lower-priced stocks tend to have increased volatility.
The third requirement for short selling is asset availability. Asset availability refers to a brokerage firm’s ability to locate the security an investor wants to short. After all, the investor borrows the security to sell from someone else and must pay them back with an equivalent number of shares later.
Why do firms participate in securities lending?
Firms provide short-sale assets to borrowers because they can earn revenues from such transactions as lenders. For mutual funds and ETFs, this means greater shareholder returns, while for banks, it increases their shareholder profits.
Familiar lenders of these shares include:
- Mutual fund/ETF management companies
- Pool investment managers
- Brokerage firms with margin users
- Banks that custody shares
The practice of securities lending to short-sellers is widespread and regulated.
Covered versus naked short selling
Covered short selling is when an investor has the arrangement through their broker to borrow securities to sell and is perfectly legal and widespread on Wall St.
Naked short selling entails selling a security without confirming that the asset is available to borrow or exists. The practice of naked shorting securities is illegal for regular investors and is only allowed by market makers and specialists in extenuating circumstances.
Market makers and specialists are entities that provide liquidity for securities through actively buying and selling a holding.
Payton is an investor who just opened an after-tax brokerage account at A-Broker and received margin trading approval.
Peyton is skeptical that real estate will continue to perform well and has identified XYZ Homebuilders stock as an ideal short-selling candidate.
Currently, XYZ is trading at $100/share, and Payton wants to short an even lot of 100 shares.
Payton deposits $5,000 into their brokerage account and proceeds to enter a short-sale transaction. A-Broker finds a lender for the securities and immediately executes the order to sell.
In the after-tax brokerage account, Payton now has $15,000 and is waiting until they are ready to buy back the stock.
100 shares * $100 sale price = $10,000, to which we add the $5,000 deposit.
Two weeks pass. XYZ Homebuilders then announces they expect revenues and profits to decline and reluctantly announces layoffs of 40% of their workforce. XYZ stock falls in value and is now worth $65.
Payton decides now is the opportune time and buys back a lot of XYZ shares for $65 each, totaling $6,500.
A-Broker returns the borrowed shares to the lender, and Payton nets a $3,500 profit.
$10,000 sale price – $6,500 purchase price = $3,500 net profit.
Not a bad return for Payton in two weeks, but what if things didn’t work as favorably?
Imagine instead that XYZ Homebuilders announces a surprise profit after two weeks and share prices jump 35% to $135.
In this alternate scenario, Payton decides to cut their losses and buys back the stock due to a favorable company outlook. Payton’s total loss is $3,500.
$10,000 sale price – $13,500 purchase price = net loss of $3,500.
But, remember how the minimum account balance for margin accounts is 30%? Therefore, A-Broker margin calls Payton for $2,550 before the shares are acquired since the minimum maintenance requirement is $4,050 in principal, and only $1,500 in principal remains in the account.
$5,000 deposit + $10,000 sale = $15,000 balance
$15,000 balance – $13,500 market/purchase price = $1,500 remaining of initial deposit
$13,500 * 0.3 = $4,050 minimum maintenance requirement level (MMRL)
$4,050 MMRL – $1,500 remaining of initial deposit = $2,550 margin call
Thus, Payton must deposit $2,550 to the account if they don’t want to close the short position. But if they close the short position, they realize a $3,500 loss. Ouch!
My example leaves out one piece of information: the cost of borrowing funds. Margin trading incurs a daily interest rate that a broker charges its customers, which will offset any profits. Thus, as the duration of the short increases, the interest paid will go up.
There is no official time limit an investor can short sell a security, and the interest expense will dictate the profitability of the endeavor.
Closing the sale (and blog post) with pros and cons
Short selling plays an essential role in the marketplace despite its negative connotation. Perhaps the four most important functions of short sales are increased asset liquidity, the creation of hedges, tamping market exuberance, and cutting down on financial fraud by firms that have misrepresented themselves to investors (since short sellers do research that exposes them).
While short sales are legal, they are not advisable to the average investor since the risks involved are substantial, and the potential losses are unlimited.
What is your experience with short selling? Is it an activity you have participated in practicing? Or perhaps you remember the scandals in short selling marketplace before the Great Recession and the regulation that soon followed. Regardless, please chime in using the comments below, and as always, have a great day.
What happens if you drop below the 50% initial margin requirement but stay above the 30% one?
Your trading will be restricted from opening new short positions, but you can still maintain previous ones. To resume trading new short positions, you must deposit additional funds. If your equity drops below 30%, you must either close the short or deposit additional funds to the account.
Is short selling illegal?
Covered short sales are legal in the United States. Naked short selling, where a seller doesn’t confirm the security is available to deliver, is not under Regulation SHO.
Is short selling a good idea?
Short selling is an advanced investing strategy that carries substantial risk that is not for the faint of heart. Employing this strategy should only be done after adequate research and understanding of the risks involved, such as an unlimited potential loss.
Can I Sell Short in My Brokerage Account?
You can short sell in an after-tax brokerage account if you are approved for margin and short selling with your brokerage firm.
How do you make money in short selling?
You make money when a stock or investment goes down in value when using a short sale. The profit occurs since you sell at a high price and then buy the security later to close the transaction for a lower purchase price.
What happens if you don’t meet a margin call on a short sale?
Your brokerage firm will close out your position and recover the funds they are owed.
How are short sales taxed?
As short-term capital gains, which are treated as ordinary income.
Mile High Finance Guy
finance demystified, one mountain at a time