Shorting has become a larger part of the cultural discussion since movies like The Big Short and market phenomenons like the Gamestop short squeeze. When someone “shorts” an investment, it means that they wish for the investment to decrease in value.
If this seems counterintuitive, it’s because it is. When it comes to shorting, you don’t buy something and sell it later. Instead, an investment is sold first, and then bought back at a later time.
How to sell something we do not own
What tends to confuse people is imagining how something can be sold before it has been bought. Consider a situation where you borrow an expensive watch from a friend and sell it for $10,000. After a month, your friend calls you and asks for their watch back. You look online and find that you can buy the exact same watch for $9,000. You purchase the watch, and are able to return it to your friend (hoping that they do not notice the difference!). What changed? Your friend has the same watch back, but you have $1,000 in your pocket.
This situation is the same with shorting stocks or ETFs. The brokerage has an inventory of shares. These shares belong to the brokerage clients who own them, but they are held by the brokerage. Individuals interested in shorting would borrow shares from the brokerage, and sell them in the market. Eventually, these shares will need to be returned to the brokerage, which would require the short seller to buy them back.
What’s the catch?
There are some risks associated with shorting that if not aware of, could come as a big surprise. They include:
Infinite loss potential: With shorting, the goal is for the security to decrease in value. Losses occur when the security increases in value. When shorting a stock or ETF, the value could theoretically rise to infinity. When shorting, it is important to have a stop loss order in place to ensure the losses do not exceed more than what is comfortable.
Forced buyback of shares: Recall how the brokerage lends shares that actually belong to their clients. In the event that the client sells their shares, the broker will first determine if there are other shares in their inventory that they can allocate to the short position. If not, they will demand that you buy back the shares immediately or the brokerage will buy them back on your dime. If this happens and the price is at a loss, there is nothing you can do.
Shorting fees: There are some securities that are in higher demand than others. Each security has a “borrow rate” – a percentage of the cost of the security. This is measured daily on the overall value of the short position. The borrow rate is higher when it is harder for the brokerage to locate shares available to short. This can change daily, but is often only charged when holding short positions overnight. For many popularly traded companies, the shorting fee can be zero.
Payment of dividends: If you are shorting a stock or ETF, you are responsible for paying any dividends that the investment would typically pay out. These shares had belonged to a client of the brokerage who was holding them, so they are expecting to receive a dividend if the company pays one and the one who shorts must provide that dividend.Summary
Shorting is the process of borrowing shares from the broker, selling them initially and later buying them back. The goal is to buy the shares back at a cheaper price than originally sold for. Potential risks are that there is no limit to how high the share price can rise and shorters may be forced to buy back shares at any time. It's a strategy to continue making profits even if the markets are going down in value.
