An Explanation and Definition of Shorting Stock
How to Short Stock and the Dangers of Shorting Stock
When a trader or speculator engages in a practice known as short selling—or shorting a stock—they are essentially borrowing the shares. The short trader borrows shares from an existing owner through their brokerage account. They will then sell those borrowed shares at the current market price. Here, the objective is that they believe the share's market price will decrease before they are forced to pay back the borrowed shares allowing the trader to pocket the difference in the two share prices.
Why Short Sell Stock?
The hope behind shorting a stock is that the stock price will decline or that the company will go bankrupt before borrowed shares are due—known as the expiration date. 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 their own pocket to cover the dividend income that is no longer available on the original shares.
Unfortunately for the investor who had their shares of stock borrowed through their brokerage firm, those replacement dividend payments aren't treated as qualified dividends. Qualified dividends 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 (KO) 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 trading 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 Profitable Outcome
A year later, you are still sitting on the short position, only you've had to make $132 in dividend replacement payments. The stock declined by 20% to $34.52 per share. You buy it back 100 shares for $3,452. Your profit before commissions and other charges is $863 on the short sale itself, less $132 in dividend replacement payments, for a net profit of $731—less any commissions paid to make the trades.
A Loss Situation
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 charges is $3,685 ($8,000 - $3,452 = $3,685).
Shorting Stock Is Not for the Inexperienced
Due to the potential unlimited losses that can be generated by short selling, brokerages typically restrict the short trading 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—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
As reported by "MarketWatch.com", 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 trader'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 raise it quickly enough, may force him to declare bankruptcy.
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.