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 through his brokerage, sells those borrowed shares at the current market price, and pockets the cash.
Why Sell Stock Short?
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.
As a condition of a short sale 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 through his brokerage firm, 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.
A Stock-Shorting Scenario
This simplified scenario illustrates the mechanics of shorting a 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 from your broker, with a market value of $4,315, and sell them, pocketing the cash. Two different scenarios could play out:
- 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, less $132 in dividend replacement payments, for a net profit of $731.
- Alternatively, say that the day after you short the stock, the company makes an announcement that it’s 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, or $8,000 repurchase cost less $3,452 cash raised from the initial sale for a net loss of $3,685 on the stock short transaction.
Shorting Stock Is Not for the Inexperienced
Due to the potential unlimited losses that can be generated by short selling, brokerages typically restrict the practice to margin accounts. In contrast, brokers forbid the practice if you use a cash account with no margin.
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, or the risk of your brokerage firm using your shares as collateral for their own financial dealings.
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 Real-World Example
A 32-year old small business owner in Arizona allegedly had about $37,000 in a brokerage account. He took a short position in a small pharmaceutical company that was on the verge of going out of business, beginning the early phases of liquidation.
A surprise buyer came in and offered to keep the firm going by purchasing a large percentage of its shares for a price that was higher than the current market price. The investor needed the shares to drop in value to make a profit; instead, in what amounted to a matter of minutes, the man found himself sitting on $144,405.31 in losses due to the increased share price paid by the new large investor.
The broker took the short-seller’s remaining equity from his account, and he now faces what is for him a life-altering margin call of $106,445.56; money that, if he can't rise quickly enough, may force him to declare bankruptcy.