Let’s recap the main points covered in this Tutorial:
- Short selling turns around the conventional investing principle of “buying low” initially and “selling high” later, by seeking to sell high first and buy low later. Short selling makes it possible to sell what one does not own, by borrowing the asset or instrument in question, selling it, and then buying it back (hopefully at a cheaper price) to replace the borrowed asset.
- Short selling can generally only be undertaken in margin accounts. Because of the higher degree of risk involved in short selling, the short seller has to ensure that he or she has always has adequate capital (or “margin”) in the account to hold on to the short position.
- A short sale should be declared as such when placing the order. The trader should also ensure that the stipulated minimum amount of capital is in the margin account prior to making the short sale. Once the shares have been borrowed or “located” by the broker-dealer, they will be sold in the market and the proceeds deposited in the trader’s margin account.
- Short selling involves a number of additional costs apart from trading commissions – margin interest, stock borrowing costs, and dividends. In addition to significant expenses, other risks associated with shorting include the ever-present risk of a short squeeze or buy-in, regulatory risk, the fact that short selling is contrary to the long-term upward trend, and a skewed payoff ratio.
- The two biggest recent changes in U.S. short selling regulations – Regulation SHO and Rule 201 – were implemented in the years after the “tech wreck” of 2000-02 and the global bear market of 2008-09. Regulation SHO, which was implemented in January 2005, specifically sought to curb the practice of “naked” short selling by imposing “locate” and “close-out” requirements on broker-dealers for short sales. In February 2010, the SEC adopted an “alternative uptick rule” or Rule 201, which restricts short selling by triggering a circuit breaker when a stock has dropped at least 10% in one day.
- Two of the most useful indicators for analyzing potential short sales are short interest and the short interest ratio.
- Timing is everything when initiating a short sale. While the window of opportunity for the short seller is a fairly limited one, the odds improve during certain times – amid a severe recession and bear market, a deterioration of fundamentals, when technical indicators confirm the bearish trend, and when valuations are elevated.
- Investors who wish to act on a bearish view with regard to a stock, sector, or the broad market, have a couple of alternatives to short selling – put options and inverse exchange-traded funds (ETFs).
- Short selling carries less risk when the security being shorted is an index or ETF, since the risk of runaway gains in them due to a short squeeze is much lower than it is for an individual stock. Short selling risk can also be mitigated by buying calls to hedge the risk of the short position going badly awry. This is the mirror image of a long stock + long protective put strategy.
- Because of its many risks, short selling should only be used by disciplined traders who are familiar with the risks of shorting and the regulations involved. Put buying is better suited for the average investor than short selling because of the limited risk. That said, short selling can be a potent strategy for speculation or hedging during bear markets.
This commentary was prepared by Elvis Picardo, who is a Portfolio Manager with HollisWealth® (a division of Scotia Capital Inc., a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada). This is not an official presentation of HollisWealth. The views, including any recommendations, expressed in this presentation are those of the presenter and are not necessarily those of the dealer. All investments involve risk and prior to investing, the specific risks should be discussed with an investment professional. ® Registered trademark of The Bank of Nova Scotia, used under licence.
This commentary may contain forward-looking statements based on current expectations and projections about future general economic factors. Forward-looking statements are subject to inherent risks and uncertainties which may be unforeseeable, and such expectations and projections may be incorrect in the future. Forward-looking statements are not guarantees of future performance and you should avoid placing undue reliance upon them.