Shorting appears to be complex and therefore out of the range of individual investors. At the most macro of levels, shorting is making an investment on the premise that a stock, market, or market segment will go down. This is exactly the same principle as investing on the long side. As you drill down into more tactical issues, it almost stays this simple.
There are several ways to invest against a company or market, all based on the simple reality that it takes 2 to tango—successful shorting requires 2 opinions, 2 beliefs, 2 sets of actions by investors—someone thinks an equity is going up and you think it is going down. Better still if most people think it is going up and you play the role of the contrarian.
So, what exactly is shorting? There are several flavors worth exploring.
- Traditional shorting—borrower beware
- Shorting with puts—limiting exposure
- Other methods—naked calls, naked puts, naked shorting
Traditional shorting—borrower beware
The oldest and most traditional form of shorting a stock involves the borrowing of shares of a company at one price (preferably a higher price) and repaying the loan with shares purchased at a lower price.
You go to a nationally owned restaurant, find the food terrible, the service indifferent, and other customers using discount coupons everywhere. You decide to short the stock. Next day you call your broker—yes, you should probably use a phone, not a mouse and laptop—and ask if they hold shares or can find shares of this company. She says yes, plenty are available, and then the fun starts. You borrow 1,000 shares, the current price of the stock being $20 a share. You immediately sell the shares and that money is put into a margin account you have set up for the purpose of shorting and nothing else. Some or all of that cash is tied up as collateral and will suffice to cover your position if the stock goes up a bit depending on your broker's requirements. However, if the stock goes up a lot—in this case, with your broker's rules, if it hits $30 or more—you start getting margin calls. And for every dollar the stock goes up you will need to put up 50 cents in collateral.
Other things to consider:
- When you borrow the shares, you pay interest to the brokerage house for this loan, and the harder the shares are to find, the higher the interest rate, and I have seen examples of 20% interest per annum.
- You may collect dividends, but you also pay them out to the person or persons you borrowed the shares from.
- If you make the mistake of co-mingling your long and short positions in the same account, and the short position starts going the wrong way, your broker can and will liquidate your long positions to cover margin calls.
Is this a good way to invest against a company and stock? Yes and no. Yes if you are a professional or institutional investor; no if you are an individual investor. Institutional investors are much better able to handle the margin calls and financial risks associated with the open-ended liability created by a traditional short position. You can do the math: If you short a stock at $20, and someone buys the company at $100, you are out 5 times your original investment. That is not the kind of liability any individual investor should face.
Shorting with puts—limiting exposure
A second way to short stocks is to use put options contracts. These contracts are the right to put the stock to a buyer at a fixed price at a date in the future. They are essentially a bet that a stock will go down. If you own a put, and you keep it through expiration, and the stock is at $20 and the put you hold has a strike price of $25, you can buy the stock at $20 and put it to the seller of the put at $25. In reality, puts are typically trading and hedging tools and only a minority of puts are exercised—most individual investors sell winning or losing put positions before expiration.
Other methods—getting naked, going broke
Naked shorting and the writing of naked calls are techniques used by speculators to short a stock without investing capital in the position, and naked shorting is, for the most part, against SEC regulations.
A naked short is the shorting of a stock without actually borrowing and selling the shares, what the SEC calls "affirmatively determined to exist." This practice is illegal. When a real short is underway, traders can either borrow shares or determine shares are available to be borrowed before they sell them short. A naked short is a position where the trader never takes possession of the shares and sells them, depressing the price, but does not complete the trade at settlement since the trader never took possession of the shares.
A naked put or call is the sale of an option without owning the underlying stock. The most aggressive form of shorting may be the sale of naked calls—you sell people the right to buy a stock at a price in the future; yet you don't own the stock—since you are assuming the price of the stock will be less than the price in the call contract. This is a common, and legal, practice among many aggressive traders looking to short thinly traded stocks with hard-to-find shares to short.
Avoid doing this because naked calls can also wipe traders out. Imagine that a struggling software company keeps failing to find a marketing partner, is burning cash, and its stock is going down—but it is too small to easily short; every attempt you make to locate the stock fails. So you write naked calls with a $2.50 strike price. This itty bitty company is selling for around $0.50 a share and you sell calls that you assume will expire worthless in 2 months for 10 cents. The company cuts a deal with an industry giant such as Microsoft or Oracle to market their product. The stock immediately runs up and the person who has bought the calls you sold exercises them around $2.50. You are out 25 times what you were paid for the call. Not a good risk, not now, not ever.