It is commonly thought that you must buy a stock in order to sell it, but this is oddly not the case. You can sell a stock you don’t have by buying it later. This is called “selling short” or a “short sell.”
The investor who makes a short sell borrows the stock now and sells it. Later, the investor purchases the stock to return it to its owner from whom they borrowed it. In between borrowing and buying the fund, the stock price moves. With a short sell, the investor is hoping that the stock will go down in price. If the stock price goes down, then the short seller will be able to purchase the stock for less than they sold it and make a profit.
Short selling is risky. When you purchase a stock long (the regular way), the worst that can happen is that the stock goes bankrupt, and you lose 100% of your investment.
In short selling, a bankrupt stock is the best thing that can happen, but the worst thing that can happen is that the stock price will rise. In fact, it could rise to multiple times its current value, and there is no limit to the amount of money you could lose selling short.
Additionally, stock prices go up more than they go down, so the odds are against short sells.
To start a short sale, you must have an account with margin that uses your own eligible securities as collateral.
Stock can be classified as easy-to-borrow (ETB) or hard-to-borrow (HTB). Hard-to-borrow stock means that there is a limited supply of a stock available for short sales. In this case, you will have to pay a daily stock borrowing fee which charges based on a stock’s price and availability.
If the original owner decides to sell their shares, with an easy-to-borrow stock, your short will continue to be borrowed. However if they are hard-to-borrow, there may be a fee to continue to borrow the shares. Also, it is possible that the shares will be unavailable, and the short will be closed out at the current market price.
If a stock pays a dividend while it is borrowed, the original lender will typically get a substitute dividend payment, and the borrower will have the same amount debited or withdrawn from their account.
Here is what a short-sell looks like at Schwab:
You can see that the quantity and market value numbers are listed with parenthesis around them to indicate that they are negative numbers.
In this example, the 4,000 shares of short VDE are a debt to the client currently valued at $205,840. If they choose to repurchase now, this is the amount they will pay to end the short sale.
The capital gains treatment of short selling is also not intuitive. Most people think that the tax treatment should begin with the short sell itself, but this is not the case. The holding period begins when you purchase the security to close the short sell and the holding period is one day. This means that the proceeds of a short sell are always a short-term capital gain or loss. There are more complex rules for shorting your own position, meaning a position that you already own.
We do not recommend short selling.
On average, you will lose 0.03% every day, 0.17% per week, 0.77% per month, and 8.81% per year on just price movements. But the stock market is rarely average. Individual stocks are much more volatile and that volatility will catch you unawares. Even if you have had a couple of wins, in the long run short selling is a losers game. When you lose, you can lose big with no limit to the amount of money that you can lose.
Even if you are sure that a given stock will go down, all the reasons you have are public knowledge. You may think that everyone else is crazy, but their craziness is the fair market value for the stock. You could get burned trying to be rational.
Photo by Blake Weyland on Unsplash