Generally, the two main reasons to short are to either speculate or to hedge.
Conventional long strategies can be classified as investment or speculation, depending on two parameters – (a) the degree of risk undertaken in the trade, and (b) the time horizon of the trade. Investment tends to be lower risk and generally has a long-term time horizon that spans years or decades. Speculation is a substantially higher-risk activity, and typically has a short-term time horizon.
Short selling is seldom classified as a core “investment” strategy. Even the most astute and experienced short sellers may shy away from labeling short selling as an investment strategy per se. Some famed hedge fund managers may hold “strategic” short positions in certain stocks or sectors for a long period of time, but their deep pockets make them the exception rather than the norm. The average trader may hold short positions for only a few weeks or months. Because of the inherently higher degree of risk and the short time horizon, short selling is more accurately classified as a speculative activity rather than as an investment strategy.
Apart from speculation, short selling has another extremely useful purpose – hedging – often perceived as the lower-risk and more respectable avatar of shorting. The primary objective of hedging is protection, as opposed to the pure profit motivation of speculation. Hedging is undertaken to protect gains or mitigate losses in a portfolio, but since it comes at a significant cost, the vast majority of retail investors do not consider it during normal times.
The costs of hedging are twofold. There’s the actual cost of putting on the hedge, such as the expenses associated with short sales, or the premiums paid for protective put options. In addition, there’s also the opportunity cost of capping the portfolio’s upside if markets continue to move higher. As a simple example, if 50% of a portfolio that has a close correlation with the S&P 500 index (S&P 500) is hedged, and the index moves up 15% over the next 12 months, the portfolio would only record approximately half of that gain, or 7.5%.
The following example illustrates the use of short selling in speculation and hedging.
Speculation: Assume you are bearish on the near-term outlook for the S&P 500, and therefore short sell the SPDR S&P 500 exchange-traded fund (SPY on the NYSE). You short sell 500 SPY units at $234 and put up $58,500 as margin for the short sale. You have a 10% profit objective and a 5% stop loss.
Scenario 1: Market trends lower
Your forecast is correct and the S&P 500 heads lower over the course of the next few weeks. Your profit target is reached when the SPY trades at $210.60, at which point you cover the short position.
Your gross profit on this trade is: ($234.00 – $210.60) x 500 units = $11,700
Your gross return on investment (ROI) = $11,700 / $58,500 = 20%
(Note: To keep things simple, we calculate gross profit, which excludes costs and expenses associated with the trade such as commissions, borrowing costs, margin interest etc.)
Scenario 2: Market trends higher
Your forecast is incorrect and the S&P 500 heads higher over the course of the next few weeks, triggering your stop loss when the SPY trades at $245.70.
Your loss on this trade is: ($234.00 – $245.70) x 500 units = -$5,850
Your return on investment (ROI) = -$5,850 / $58,500 = -10%
Hedging: Assume you have a $250,000 portfolio of U.S. blue-chips that trade in lockstep with the S&P 500. You are concerned about the near-term outlook for the U.S. equity market, and think 10% downside is a possibility. But as a long-term investor, you are reluctant to sell your holdings and would prefer to hedge your downside risk through a short sale of the SPDR S&P 500 exchange-traded fund (SPY). With the SPY units trading at $234, you therefore short 1,068 units to hedge your portfolio.
Scenario 1: Market trends lower
Your concerns prove to be correct and the S&P 500 heads lower over the course of the next few weeks. When the decline in the index reaches 10%, you cover your short position at a SPY price of $210.60, at which point your profit-and-loss statement (P&L) looks like this:
Loss on $250,000 portfolio due to 10% market decline = -$25,000
Gain on hedging strategy (short sale of SPY units) = ($234 – $210.60) x 1,068 units = $24,991.20
Overall gross P&L = -$25,000 + $24,991.20 = -$8.80
Thus, the gain on the short SPY position almost perfectly offset the loss on the long portfolio, effectively hedging its downside exposure.
Scenario 2: Market trends higher
Your forecast is incorrect and the S&P 500 heads higher over the course of the next few week. When the index has gained 5%, you acknowledge that your view many have been incorrect and cover the short position with the SPY units trading at $245.70. Here’s what your P&L would look like:
Gain on $250,000 portfolio due to 5% market advance = $12,500
Loss on hedging strategy (short sale of SPY units) = ($234 – $245.70) x 1,068 units = -$12,495.60
Overall gross P&L = $12,500 – $12,495.60 = $4.40
Here, putting on the hedge resulted in the portfolio being unable to participate in the market’s upward move.
While we have assumed that the entire position is hedged in this example, in reality, you may decide to hedge only a part of the position. The proportion of the hedged part of the portfolio in relation to the value of the entire position is known as the hedge ratio. If $50,000 of a $250,000 portfolio is hedged, the hedge ratio is 0.2.
Short Selling and Margin
Short selling can generally only be undertaken in margin accounts, which are accounts offered by brokerages that allow investors to borrow money to trade securities. 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.
Short selling is the mirror image of buying stocks on margin. Thus, since the short seller is putting up less than the full value of the securities sold short, margin interest is charged by the broker-dealer on the balance amount of the transaction.
Note that although the short seller receives an inflow of funds from the shares sold short, these funds technically do not belong to the short seller, as they are obtained from the sale of a borrowed asset. The short seller therefore has to deposit an additional amount in the margin account as collateral for the short sale.
As with stocks purchased on margin, the margin requirement on short sales depends on the price and quality of the stock, since these determine the risk associated with the short position. Hence, blue-chip stocks with prices in the mid to high single digits have substantially lower margin requirements than speculative small-cap stocks that trade in the low single digits.
For instance, the margin requirement on a short sale may mandate that 150% of the value of the short sale be held in a margin account when the short sale is made. Since 100% comes from the short sale, the trader has to put up the balance 50% as margin.
Thus if a trader shorts 100 shares of a stock trading at $50, this margin requirement would require the trader to deposit an additional $2,500 (50% of $5,000) as margin. This margin is constantly monitored by the broker-dealer to ensure that it stays above the minimum mandated level (known as the “maintenance margin“) and would need to be topped up without delay (the dreaded “margin call”) by the trader if the short sale does not work out—if the stock, instead of declining, appreciates significantly.
The following four points should be noted with regard to short sales in margin accounts:
- The short seller does not receive interest on the proceeds of a short sale.
- Margin maintenance requirements – ensuring that there is adequate margin to hold on to the short position – are based on the current market price of the security, and not on the initial price at which the security was sold short.
- Margin requirements can be fulfilled through contributing cash or eligible securities to the account.
- If the short seller is unable to meet the margin requirements, the broker-dealer will usually close out the short position at the prevailing market price, potentially saddling the short seller with a huge loss.