The term short-selling stock refers to the practice of selling securities that are not owned. Investors will short-stocks when they believe a stock's market price is going to decline.
In this article, we are going to cover the stock market investment strategy referred to as short selling. We will explain the four steps involved with this technique, as well as the risks and rewards involved with this type of investment. We will also talk briefly about some specialty approaches such as "naked shorts" and "shorts against the box." Finally, we'll finish up with several examples.
When an investor is selling a stock short, they have a negative or "bearish" outlook with respect to the price of the stock they're trading. Day traders and hedge fund managers will often sell-short in an attempt to profit from falling prices on securities they believe are overvalued.
Stock exchanges will typically report the total number of shares of a security that have been sold-short by investors, and that have not been repurchased to settle positions in the market. This measure is referred to as short interest. This ratio is calculated by taking the monthly short interest volume on the entire stock exchange, and dividing it by the average daily trading volume. A high ratio normally indicates bearish feelings towards the market.
On the other hand, bullish investors see a high ratio as a positive sign for the market's outlook. These investors believe that short interest positions must eventually be covered, and the increase in demand for stocks necessary to cover open positions will drive the price of stocks back up.
The process of selling stocks short consists of the following four steps:
The investor makes money from this strategy when the price of the stock they're borrowing declines. These investors have a negative outlook on the security, and anticipate the price of the stock will fall. In fact, "selling-short" is the opposite of "going-long," and normally when the seller borrows stock, the broker they're working with borrows the stock from an investor that is taking a long position.
In the United States, sellers must ensure their broker can make delivery of the securities. This is referred to as "locate," and brokers will not allow customers to short a stock before assuring that shares can be borrowed.
The technique known as naked short selling or "naked shorting" is the practice of selling a stock short without first borrowing the shares, or making an "affirmative determination" that the shares can be borrowed. This practice violates U.S. securities law. In January 2005, the SEC enacted Regulation SHO to reduce the practice of naked short selling, and the subsequent practice of "failure to deliver" securities.
"Shorting against the box" occurs when an investor sells-short securities they already own. The name is derived from the thought of selling-short the same securities that are held in a safe deposit box.
The strategy behind this approach is to lock-in "paper" profits on the investor's long position, without having to sell the stock. If the price of the stock held by the investor increases or decreases, then the profits, or loss, on the short position are offset by the profit, or loss, on the long position.
The IRS views "shorting against the box" as a "constructive sale" of a long position, which triggers a taxable event unless certain conditions are met.
Since the investor is hoping the price of the borrowed security will fall, the biggest risk of taking this position is the price of the stock increases. If that occurs, and the investor is using a margin account, then a margin call will be made if the required maintenance is not met. This can occur when the stockholder's equity position falls below a prescribed percentage.
If the price of the stock remains at an inflated level, then the investor may eventually be forced to close out their position, and realize a loss on the transaction. Since there is no theoretical upper limit to a stock's price, the investor's loss is also without theoretical limits. Since the price of a stock cannot fall below $0 per share, the upper limit for profit is the total value of the stock sold short.
One strategy that traders use to limit their losses is to place a "stop loss order." When shorting a stock, the investor can issue what is called a stop-loss buy order at a set price. The order will be executed if the stock's price reaches the stop-loss price. When this happens, the short position on the stock is closed out, thereby placing a limit, or cap, on losses.
In this example, the investor is looking to borrow 100 shares of Company X stock currently selling at $50 per share. The seller borrows the 100 shares of Company X from their broker, and immediately sells the shares on the market for $50 per share x 100 shares or $5,000.
Let's assume that at a future point in time the price of Company X stock drops to $40 per share. The investor would then buy back the 100 shares of Company X at $40 per share, or $4,000, and make $1,000 in profit.
The theoretical limit of profitability in this example occurs if the price of Company X's stock falls to $0 per share. At that point, the investor purchases the stock of Company X for $0 and makes a profit of $5,000.
On the other hand, if the price of Company X's stock were to rise to $1,000 per share (not probable, but possible), then the investor would be forced to pay $1,000 per share x 100 shares or $100,000 and realize a loss of $95,000 on the transaction.
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