Short selling is an advanced trading approach, available to margin account holders only, that allows investors who are comfortable with the risks—such as the potential for loss if the stock price rises, a change in the rate of interest you're charged for borrowing a stock, or a lack of availability that forces you to close out your position with a loss—to potentially profit from downward moves in stocks. When selling short, an investor sells a stock today at one price in the hope that it will decline in value, giving them the opportunity to buy it back—or cover a short—at a lower price. Using this approach, investors have the opportunity to potentially earn gains when markets go up and down.
A hypothetical example of short selling
To understand the concept of short selling, take a look at a hypothetical situation involving a stock currently trading at about $50 per share. You've been doing some research, and think that at some point in the future the price of that stock will fall.
So you sell "short" 100 shares at $50 per share in your margin account. This trade generates $5,000, part of which you're required to post as collateral. The amount of collateral you're required to post depends on a range of factors and may vary from trade to trade. In the meantime, you borrow the shares with the assistance of your broker, which your broker then delivers to the clearance agency on the date that trade settles.
If the stock should lose value, trading down, for example, to $40 per share, you may decide to buy those 100 shares back, also known as covering your short, at a total cost of $4,000. In this scenario, your trade has generated a gross profit of $1,000, not including costs such as brokerage commissions.
However, there's also a chance that the stock you've chosen to short could increase in value. Say for example, that the stock price instead rose to $60 instead of falling to $40. In this scenario, when you cover your short, your total cost would be $6,000, resulting in a $1,000 loss.
While there are other costs involved, like brokerage commissions, administrative fees, and the cost technicalities involved with borrowing the stock, that's the basic premise of short selling.
How to sell a stock you don't currently own
When you sell stocks from your portfolio, those shares are delivered, through a clearance agency, to the buyer on the other side of the trade. This happens on the settlement date, which falls 2 days after the trade date. The same holds true when you execute a short sale. The only difference is that instead of delivering something you already own, you have to borrow the shares from your broker. Then, on the settlement date, your broker delivers those borrowed shares to the clearance agency, and the agency delivers shares to the buyer on the other side of your trade.
When you borrow a stock you may have to pay interest on that "loan," just as you would when you borrowed any other type of asset. The rate of interest is generally set by broker-dealers and is dependent upon such factors as the availability of shares. In general, fewer available shares means a higher rate of interest. Any stock can theoretically be sold short, as long as it can be borrowed. Availability, or how easy it will be for your broker to locate shares, should be an important part of your decision. Not only could it impact the interest rate you may have to pay on your "loan," shorting hard-to-borrow stocks increases the likelihood that you will be bought in. In the case of a buy in, you're forced to cover your short if the lender pulls back the shares that your broker is borrowing, which makes those shares unavailable.
Another thing to remember is that many stocks pay quarterly dividends to shareholders. If you happen to be short a stock on the date that dividend is credited to shareholders—also known as the record date—you're responsible for paying that dividend to the person from whom you borrowed those shares, called payment in lieu of dividends. A number of factors—including brokerage commissions, cost of borrowing, administration fees, and possible dividends—can impact the profit or loss of a short sale trade. Depending on the length of time you maintain your short position, you may be able to deduct these payments, thereby reducing the cost basis of your trade, but only if you itemize deductions.*
Some potential uses of short selling
The following are examples of scenarios where you might employ short selling. Note that this is not an exhaustive list; there may be other types of situations in which short selling could potentially make sense for you. This list should also not be construed as any type of investment recommendation by Fidelity.
Hedge your positions
Let's assume you recently purchased the shares of several companies in a particular industry, and those stocks have appreciated in value. While you're still optimistic about that industry and the market in general over the long term, you have some short-term concerns. Rather than liquidate your positions, which could generate gains that would be taxed at higher ordinary income rates if the shares had been held for less than one year, you short another stock within that industry. If the market or the industry in question experiences a decline, the profit you can potentially make on that short sale may reduce the impact of that decline on your overall portfolio.
Anticipate a downward move in a specific stock
You've been reading about a company whose stock price has continued to move higher in spite of several consecutive quarters of declining earnings. You believe these deteriorating fundamentals will catch up with this stock at some point in the near future, so you sell shares short in the hopes of covering your short at a lower price.
Anticipate a downward move for an entire industry
You foresee tough times ahead for a specific industry, due to factors like the rising price of a key commodity or an expected change in the regulatory environment that could negatively impact profits. So you choose one of the highest profile companies in that industry and sell its shares short, assuming that the price will fall.
Extend a trade after option expiration
You've written naked calls that are about to expire in the money, requiring you to deliver the requisite number of shares of the underlying stock. However, you still believe that that stock is poised for decline. Rather than repurchase your calls and write more that are scheduled to apply at a later date, you let your original calls expire and deliver the shares, maintaining your bearish position.
Some risks of short selling
The stock may increase in value
If you sell a stock and it rises in value, you will lose money if you cover that short at the higher price.
Limited potential gains, unlimited potential losses
When you buy a stock, your greatest risk is that the stock price will fall to zero, meaning you will lose all of your initial investment. But when you short a stock, your downside is far greater. For example, say you short a stock at $10 per share. The most you can make is $10, if the stock goes to zero. Theoretically though, the stock could go to $100 or even higher, making it impossible to predict your potential loss in a short sale. This is why it’s important to carefully monitor your short positions.
Market may have already digested bad news
Many traders short a stock in anticipation of news that will have a negative impact on the price of that stock. In some cases though, that news has already been widely known, so the stock price already reflects it. When buying or shorting a stock, it’s important to look at its recent movement.
Your interest rate may change
It's very possible that the cost of borrowing a stock you've shorted could change significantly without warning, as interest rates are driven by the availability of shares and can change on a daily basis. It’s even possible for you to be quoted a rate on the day you execute a trade, only to have that rate change the day the trade settles. Note that a rate change can significantly impact the profit or loss of any short sale.
You may experience a buy in
At some point, a lender may pull back the shares that the broker is borrowing on your behalf, which makes the shares unavailable. While your broker may be able to obtain additional shares on your behalf, in some cases no shares may be available. This is known as a buy in. Should this occur, you may have to cover your short by purchasing shares in the open market. If the stock has risen in value since you originally shorted it, you will realize a loss on the trade.
Your trade may fail
On the day you execute your trade, your broker will check on the availability of shares. Once those shares are located—which is another way of saying that your broker has found shares that can be delivered for settlement—you're able to execute your trade. However, on the day the trade settles, 2 trading days after the trade takes place, those shares may no longer be available. If your broker cannot deliver the shares for settlement, you’ll be forced to cover your short by purchasing these shares in the open market and may lose money if the stock price has increased.
You may receive a margin call
Since short sales must take place in a margin account, the rules of your margin agreement apply. This means that you must maintain the minimum equity required by the terms of your agreement or face a margin call. In most cases the margin requirement is 35%, but, depending on the stock involved, your broker could raise that requirement to 70%. If market fluctuations reduce the value of the equity in your account, your broker may issue a margin call, which you must meet by adding funds to your account. Failure to meet a margin call could result in your broker either selling securities in your account or buying in your short positions without consulting you, even if the trade is currently going against you.
Rules governing short selling
The Securities and Exchange Commission (SEC) has established certain restrictions on short selling when a stock is experiencing significant downward price pressure. Specifically, Rule 201 forbids the execution or display of a short sale order of a security at or below the current national best bid if the price of that security has fallen by 10% or more from the prior day's closing price.
For a full explanation of this rule and all of the SEC's rules governing short sales, visit www.sec.gov.
Short selling at Fidelity
Note that short sale orders may be executed during Premarket trading (8:00 a.m. to 9:28 a.m. EST), regular trading hours (9:30 a.m. to 4:00 p.m. EST), and After-Hours trading (4:00 p.m. to 8:00 p.m. EST). No conditional or trailing stop orders in connection with a short sale may be entered. In addition, only U.S. stocks may be sold short. Also, note that some securities may be ineligible to short, or there may be insufficient shares available to borrow in order to meet your request. All short sale orders may be reviewed by a Fidelity representative to determine the availability of shares. When you're placing an order to sell short on the Trade Stocks page, the number of shares available to borrow for that security appears next to the Quantity field once you've entered a valid symbol in the Symbol field. This number reflects share availability at a specific point in time; shares may not be available to borrow when you enter your order or when the trade settles. If insufficient shares are available at the time you place your order, you will receive an error message. If your order proceeds through verification and confirmation, shares have been located to cover an executed short sell order. However, note that share availability may change between the time the trade is executed and the settlement date, which usually takes place 2 business days later. If this occurs, the trade will fail and you will have to cover your short by repurchasing the shares in the open market, which could result in a loss.
If the stock you've shorted is classified by Fidelity as Hard to Borrow, the interest rate you pay on the loan of these stocks may vary depending on a number of factors, including availability and supply and demand of shares. You can track these interest rate fluctuations by navigating to the Portfolio Positions page and clicking on the Hard-to-Borrow (HTB) icon next to a specific short position. This will reveal details about the position, including the current interest rate on your security loan.