Selling short

Generalities

Investors can make a profit regardless of where the market goes. Most gain when the market goes up, but there are other ways to make a return. Selling short allows investors to bet against an investment and make money if market values fall.

Selling short is more complex than going long (buying) a security. Investors must work with their broker-dealer to determine if the brokerage firm has access to the security that will be sold short. The investor borrows the security from the brokerage firm and agrees to return it sometime in the future. Next, the investor goes to the market and sells the security immediately.

After the security is sold, the investor hopes that the market price falls. They must eventually buy back the security and return it to the broker-dealer; the lower the repurchase price, the higher the profit. For example, an investor sells short stock for $75. A few weeks later, the stock falls, and the investor repurchases the stock at $60 to lock in a $15 per share profit.

Sometimes thinking through an analogy helps with understanding short sales. Imagine this scenario - you believe the price of a concert ticket will fall due to a lack of demand, and you want to profit from it. If a friend had a ticket to the concert, you could borrow their ticket and promise to return it sometime before the concert. After obtaining their ticket, you sell it online for $50.

Let’s say you were right; demand for concert tickets is underwhelming, and the tickets are selling for $40 the day before the concert. You could buy the ticket and give it back to your friend. You just made a $10 profit from the price falling. Selling short works the same way.

Selling short comes with significant risk potential and can result in considerable losses if the market rises. For example, suppose you sold short stock (or concert tickets) for $50 because you expected demand to fall. Instead, there’s overwhelming demand, which results in the market price rising to $200. If you bought back the stock (or concert ticket) at this price, you would have a $150 loss (per share or ticket).

There is no ceiling to the market, and market prices can continue to rise an unlimited amount. The higher the price, the more expensive the repurchase is and the more significant the loss.

Selling short securities is risky, but also provides investors with a way to make money in a bear (falling) market. Only the most sophisticated (knowledgeable and wealthy) investors should consider selling short.

Logistics & dividends

Selling short securities involves several protocols and procedures. First, an investor must open a margin account, a specific type of brokerage account. Investors commonly utilize margin accounts to leverage themselves, but this account type also facilitates short positions.

The investor can place a short sale transaction request once the account is open. When the broker-dealer receives the request, the security must be located. As discussed above, broker-dealers lend securities to investors to facilitate short sales. While the firm can lend securities it owns, most securities sold short are obtained from other customers. It’s a bit complex, but let’s explore an example together. Assume Robert and Jennifer both maintain 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 trade request, E-Trade could lend* Robert’s stock to Jennifer. Robert won’t even know when this occurs, as it will seem like the stock still appears 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.

Good news - the specifics relating to the “behind the scenes” protocols for short sales are unlikely to be tested. However, you may encounter a question relating to dividends.

Back to our example above - Jennifer sold short Robert’s 100 MCD shares. Technically, the shares are not in Robert’s account anymore (even though it seems they are). 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.

While this system may seem unfair to short sellers, it’s usually a wash. In a future chapter, we’ll discuss how dividend distributions result in market price declines. 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. Remember, short sellers make gains when market prices fall. While paying the dividend out of pocket isn’t optimal for the short seller, the drop in the stock’s market price helps the short seller recoup the paid dividend.

Bottom line - investors are required to pay dividends on the stocks they hold in short positions.