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.” The aim when shorting a stock is to generate profit from stocks that decline in value. There are potential 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 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 shorting stocks as part of an investment strategy 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) and only appropriate to those who are comfortable with the inherent risks.
Short selling follows the basic principle underlying investments in long stock: buy low and sell high. But a short sale works backward: 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. Here’s an example.
Suppose there’s a stock trading at $40 that you believe to be overpriced, and you’d like to get short to take advantage of a potential move to the downside.
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’d get the benefit of the stock drop, but you’d 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.
Some investors and traders use margin in several ways. 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:
Learn the benefits and risks of margin trading.
And now, a few of the risks:
With proper risk management techniques, shorting stocks can potentially enhance your investment strategy. But it isn’t for every investor.
If you’re not sure whether short selling or margin trading might be appropriate for your financial profile, risk tolerance, or financial goals, contact a representative for assistance in making the assessment. For additional videos, resources, and support on margin trading, visit this TD Ameritrade margin trading page.
Shorting a stock 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 to 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.
How are HTB fees calculated? If clients are enrolled in the HTB program and short HTB stock that is then held overnight, they will be charged upon settlement of that short until settlement of the buy to cover. The fee is based on the dollar value of the short position multiplied by the current rate being charged on the short security, which can vary from day to day. It is quoted as a percentage of the value of the short position (such as -3.5% annualized). This rate is representative of the demand/price within the securities lending market. Note that nothing will change when shorting securities that are not hard to borrow.
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Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
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