Short Selling Definition - An Explanation of Shorting Stock
How to Short Stock and the Dangers of Shorting Stock
When an investor or speculator engages in a practice known as short selling, also called shorting a stock, he or she borrows shares of a company from an existing owner, sells those borrowed shares at the current market price, and pockets the cash.
As a condition of this transaction, the short seller promises to replace the borrowed stock at some point in the future, while making dividend replacement payments out of his or her own pocket to cover the dividend income that is no longer available on the original shares.
Unfortunately for the investor who had his or her shares of stock borrowed, those replacement dividend payments aren't treated as qualified dividends, which are entitled to tax rates that are nearly half of the ordinary tax rates.
The hope behind shorting a stock is that the stock price will decline or that the company will go bankrupt, leading to total ruin for the equity holders. The short seller can then buy the stock back at a much lower price, replace the borrowed shares, and pocket the difference, adjusted for any dividend replacement payments that were required along the way.
An Example of Shorting Stock
Let's look at a simplified scenario involving shorting stock. Imagine you wanted to short 100 shares of The Coca-Cola Company because you thought it was going to report lower-than-expected earnings as a result of the strong dollar depressing its income.
The stock was currently at $43.15 per share. You borrow the one hundred shares, with a market value of $4,315, and sell them, pocketing the cash. Two scenarios play out in two alternate universes:
- A year later, you are still sitting on the position, only you've had to make $132 in dividend replacement payments. The stock declines by 20 percent to $34.52 per share. You buy it back for $3,452. Your profit before commissions and other small charges is $863 on the short sale itself - $132 in dividend replacement payments, or $731.
- The day after you short the stock, an announcement is made that the company is being acquired for $80 per share. You must now repurchase the 100 shares, paying $8,000 for the replacement. Your loss before commissions and other small charges is $3,685 ($8,000 repurchase cost - $3,452 cash raised from initial sale = $3,685 loss on stock short).
Most New Investors Should Avoid Shorting Stock
Due to the potential unlimited losses that can be generated by short selling, the practice is restricted to margin accounts. In contrast, cash accounts forbid the practice.
If you want to stop short sellers from being able to borrow your shares without your permission, you need to open a cash account. This is generally good practice, anyway, as it also goes a long way toward eliminating rehypothecation risk.
The combination of unlimited losses and a margin account requiring an unlimited personal guarantee, as all of them do, can be especially catastrophic for inexperienced investors and speculators who don't fully understand the risk they face whenever they establish a short position without some sort of offsetting protection, such as buying an appropriately-matched out-of-the-money call option at a relatively inexpensive premium.
A 32-year old small business owner in Arizona had approximately $37,000 in a brokerage account. He took a short position in a small pharmaceutical company that had planned on going out of business, beginning the early phases of liquidation.
A surprise buyer came in and offered to keep the firm going. In what amounted to a matter of minutes, the man found himself sitting on $144,405.31 in losses. The broker took all of his equity and he now faces what is for him a life-altering margin call of $106,445.56; money that, if he can't raise quickly enough, may force him to declare bankruptcy. You can read more about his disastrous trade in this case study.
If you want to understand short selling a bit more, read The Basics of Shorting Stock for a full explanation.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.