Short selling aims to provide protection or profit during a stock market downturn, but it can be risky. Plus it requires a margin account. Learn the mechanics of shorting a stock.
If anything is certain about the markets, it’s that they fluctuate. They go up and they go down. Bull markets and bear markets. It’s like traveling a mountain range, across peaks and valleys. Sure, over longer periods, the upward cycles in the stock market tend to be larger than the downward cycles, but many of the downturns have been steeper and faster. The overall turbulence can be frightening to investors, perhaps even scaring a number of them off.
Perhaps you’re wondering if there’s any way to capture the upside during a market downturn, or more specifically, any way to profit when a stock, sector, industry or the broader market enters a short-term correction or a longer-term bear market. The answer, with a few caveats that we’ll explore, is yes. Investors can profit from a market decline.
You’re probably familiar with the terms “short selling,” “going short the stock market,” ”shorting a stock” or “selling stocks short.” Short selling aims to generate profit from stocks that decline in value. There are benefits to going short, but there are also plenty of risks.
We also can’t neglect the stigma attached to short selling. After all, shorting a stock is all about generating profit from a company’s partial or total decline. But short sellers play an important role in the a healthy market—the matching of buyers and sellers, and providing liquidity and price discovery to the market.
So if you’re new to this way of investing and would like to learn more, let’s start by exploring the basic mechanics of a short sale.
But a word of caution: the short selling strategy is available only to investors with margin trading privileges (more on that below), who are comfortable with the inherent risks.
Short selling follows the basic principle underlying all investments: buy low and sell high. But a short sale works backwards: sell high first, and (hopefully) buy low later. But how can you sell a stock that you don’t already own?
You “borrow” it from another investor with the help of your brokerage firm.
Shorting a stock—a hypothetical example:
A word on dividends: If the company paid any dividends during the time you were short, your account would be reduced by the amount of the dividend. Why? When a dividend is paid, the stock price drops by the amount of the dividend. For example, if a stock is at $40 and the company pays a $1 dividend, the owner of record gets the $1, and the stock value is reduced, all else equal, to $39. So if you held a short position on the ex-dividend date, you would get the benefit of the stock drop, but you essentially “pay” the dividend. In and out.
In a nutshell, that’s how short selling works.
But there’s one more step that might make things slightly more complicated.
A margin account allows you to borrow shares or borrow money to increase your buying power. In this case you can sell short marginable stock with up to twice the buying power of a traditional cash account. The securities you hold in your account act as collateral for the loan, and you pay interest on the money borrowed.
The traditional margin trading example is summarized in figure 1.
Margin accounts and margin trading can be risky, so it’s important to understand the risks before you jump in. If, you're interested in applying for margin trading privileges, log in to your account and follow the instructions in figure 2 below.
Let’s start with the potential benefits:
And now, a few of the risks:
With proper risk management techniques, short selling can potentially enhance your investment strategy. But it isn’t for every investor.
Short selling allows you to sell something you don't own, so traders must understand the regulatory requirements. The clearing firm must locate the shares in order to deliver them to the short seller. Shares may be hard to borrow because of high demand, a small number of outstanding shares ("float"), or increased securities volatility. If the stock loan department is unable to deliver the shares for settlement, it may call for a “buy-in,” meaning the borrower must buy the shares in the open market to cover the position. If the stock price has increased, the borrower will lose money.
Also, borrowers of certain “hard-to-borrow” (HTB) shares may be subject to an additional fee in order compensate the stock loan department for the cost of locating and maintaining its supply of such HTB shares. If you open and close a short position intraday (meaning you don’t hold it overnight), you will not be subject to a fee. However, if you hold the position longer, an HTB fee, based on the notional value of the short position and the annualized HTB rate, will be assessed.
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Margin trading increases risk of loss and includes the possibility of a forced sale if account equity drops below required levels. Margin is not available in all account types. Margin trading privileges subject to TD Ameritrade review and approval. Carefully review the Margin Handbook and Margin Disclosure Document for more details. Please see our website or contact TD Ameritrade at 800-669-3900 for copies.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
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