Investors can potentially profit in different market conditions. Many investors earn returns when prices rise, but there are also strategies designed to benefit when prices fall. Selling short is one of those strategies - it allows an investor to bet against a security and profit if its market value declines.
Selling short is more complex than going long (buying) a security. You’ll work with your broker-dealer to confirm the firm can access (locate) the security you want to sell short. The basic process looks like this:
After the sale, the investor hopes the market price falls. At some point, the investor must buy the security back and return it to the broker-dealer. The lower the repurchase price, the higher the profit. For example, an investor sells short stock at $75. A few weeks later, the stock falls, and the investor repurchases it at $60, locking in a $15 per share profit.
An analogy can make the mechanics easier to picture. Imagine you believe the price of a concert ticket will fall due to weak demand, and you want to profit from that decline. If a friend has a ticket, you could borrow it and promise to return it before the concert. After borrowing the ticket, you sell it online for $50.
If you’re right and demand is underwhelming, the day before the concert the ticket might be selling for $40. You could buy a ticket for $40 and return it to your friend. Your profit is $10, because you sold at $50 and bought back at $40. Selling short works the same way.
Selling short also comes with significant risk. If the market price rises instead of falls, the short seller must still buy back the security to return it. For example, suppose you sold short stock (or a concert ticket) for $50 because you expected demand to fall. Instead, demand surges and the market price rises to $200. If you buy back at $200, you have a $150 loss (per share or ticket).
A key risk is that there’s no ceiling on market prices. Prices can rise without limit, which means potential losses on a short position are theoretically unlimited. The higher the price goes, the more expensive it becomes to repurchase the security, and the larger the loss.
Selling short is risky, but it can provide a way to profit in a bear (falling) market. Only the most sophisticated (knowledgeable and wealthy) investors should consider selling short.
Selling short securities involves specific protocols and procedures. First, an investor must open a margin account, which is a type of brokerage account. Investors often use margin accounts to leverage themselves, but margin accounts also allow short positions.
Once the account is open, the investor can place a short sale order. When the broker-dealer receives the request, the security must be located. Broker-dealers lend securities to investors to facilitate short sales. A firm may lend securities it owns, but most securities sold short are borrowed from other customers.
Here’s an example. Assume Robert and Jennifer both have accounts at E-Trade. Robert is long (owns) 100 shares of McDonald’s Corp. stock (ticker: MCD), and Jennifer wants to sell short 100 shares of MCD. When Jennifer submits the short sale request, E-Trade could lend Robert’s shares to Jennifer. Robert typically won’t know this has happened, and the shares may still appear in his account.
*Only investors that have signed the loan consent form are eligible to have their securities lent out to other customers. This form is typically presented to customers when opening margin accounts, which is discussed in further detail later in the Achievable materials.
The detailed “behind the scenes” mechanics of how shares are borrowed are unlikely to be tested. Dividends, however, are a common testable point.
Back to the example: Jennifer sold short 100 shares of MCD that were borrowed from Robert. Even if the shares still appear in Robert’s account, the shares have been lent out. MCD is a dividend-paying stock, so what happens when a dividend is paid?
It becomes Jennifer’s responsibility to pay the dividend to Robert. If MCD pays a $1 dividend per share, Jennifer must pay $100 total ($1 x 100 shares) to Robert’s account.
This may seem unfavorable to the short seller, but it’s often close to a wash. In a future chapter, we’ll cover how dividend distributions typically lead to a decline in a stock’s market price. If MCD’s Board of Directors declares a $1 dividend, MCD stock is expected to decline by $1 at the start of the ex-dividend date. Since short sellers benefit when prices fall, that expected price drop can help offset the dividend payment.
Bottom line - investors are required to pay dividends on the stocks they hold in short positions.
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