What Is Short Selling?

You probably heard the news that the SEC halted short selling on 799 financial stocks last week. The SEC did this in order to reduce downward pressure on financial stocks, and hopefully, restore price stability and investor confidence. Here’s an excerpt from the SEC web site:

Under normal market conditions, short selling contributes to price efficiency and adds liquidity to the markets. At present, it appears that unbridled short selling is contributing to the recent, sudden price declines in the securities of financial institutions unrelated to true price valuation. Financial institutions are particularly vulnerable to this crisis of confidence and panic selling because they depend on the confidence of their trading counterparties in the conduct of their core business.

So, what is short selling exactly?

Short Selling

Short selling is the selling of a stock that you don’t own in hope that the price goes down. More specifically, you’re borrowing shares from your broker, sell the shares, and deposit the proceeds to your account. Later on you close your short position by buying back the same number of shares (short covering) and returning them to your broker.

• If the price drops, you can buy back the shares at a lower price and keep the difference as profit.
• If the price rises, you have to spend extra money to buy back the same number of shares, and you lose money.

Since you don’t own the stock, you are responsible for paying the lender any dividend during the course of the loan. If the stock splits, you’ll have to buy back twice the number of shares (at post split price which is usually half).

Why Do Investors Short Sell?

In general, investors make money when the stock price move up.  Short selling allows investor to make money when the stock price goes down.  Investors that short sell in hope of downward price movement is said to be speculating.  For example, sales of financial stocks during the Financial Crisis of 2008 before the ban was a speculation that these financial stocks will continue to lose value due to the credit crisis.  People rushed out to short sell financial stocks so that they can later buy back shares at much lower price and pocket the difference.

Short Selling As A Hedging Tool

A second reason for short selling is called hedging.  Occasionally, an investor may want to maintain his long stock positions, but does not want to lose money due to short-term price drop.   In this case, he could short sell the same number of shares as his long position, and the stock will not be affected by any price movement while it’s hedged.  Essentially, the amount of money he spent on commission is his insurance policy against price movement.

Short Selling Risks

Since stock price tends to move up over a long period of time, short selling is considered riskier than normal investing.  In fact, you could theoretically lose an infinite amount of money to short selling!  For example, imagine how much money you would owe if you sold Microsoft short on Black Monday, 1987 and never covered your position.  Additionally, you could be subjected to a phenomenon called short squeeze where a sudden price increase causes many short sellers to cover their position and further drive up the price (and you lose more money).

That’s short selling in a nutshell.  It’s something that I have never done before as an investor because I don’t like the the speculative nature and higher risk.  Have you done it before, and what have you learned from the experience?