A Guide to Short Selling – What to Know

Cobra Trading
Aug 8, 2022

 

Most investors and traders embark on their market journey first by identifying companies they believe are undervalued or have room to grow given their current stock price. Once identified, the investor or trader purchases a number of shares in the company, hoping the stock price will rise so they can therefore profit by selling the shares at a higher price.

 

This strategy has some positive benefits. First, it allows people to invest in companies they believe in, which makes for a more genuine hope for the companies’ success. It also limits any potential losses, due to the stock price not having the ability to go under $0.00. Thus, the most one can lose is the Purchase Price of the Stock – $0.00 = Maximum Possible Loss per Share. 

 

As investors and traders become more seasoned with the process of buying and selling stocks, they may start to branch out to other areas of the industry. Some may look into stock options (a contract to purchase or sell a stock at a specified time and price) while others may start to look into the futures or bond markets. Others, however, may begin to wonder, can I profit if a stock declines in value?

 

This is where short selling comes in.

Short selling (shorting) a stock is the process of selling stock in the hopes the company will decline in value, the price will drop, and you can purchase the stock back at a lower price. The investor or trader then profits from this trade because they still used the old adage, “buy low, sell high,” they just did it in reverse order by entering the sell side of the trade first.

 

The mechanics of short selling are considerably different from the mechanics of purchasing stock. First and foremost, in order to short a stock you have to receive a valid short locate of the stock prior to executing any short sale. This can happen in a couple of ways; first, the stock may be on a list known as an Easy-to-Borrow list. This is a list of companies whose shares are readily available to borrow from a large number of sources, hence there is a reasonable expectation the shares will be available to deliver on settlement. A valid short locate can also occur when your broker secures a locate on your behalf. The broker will do so by simply borrowing the shares from someone who owns the stock already and is willing to lend the shares out to the open market.

 

Why would a person loan their shares out to the general market to sell? It seems counterintuitive, doesn’t it? If the investor or trader in question wants the stock price to rise, it is confusing as to why someone would sell the shares. In doing so, they would appear to be allowing more selling pressure on company shares they want to rise in price, not fall. 

 

While there are too many factors which play into the answer for this question to address them all, there are two primary reasons. The first is obvious: money. Someone is willing to pay them a fee for the loaned shares. Secondly, they don’t control whether or not their shares are loaned out due to the terms of the account in which they were purchased.

 

So, does that mean they don’t own them? Simply put, yes, they own the shares. However, the shares are still subject to the account agreement they were purchased under. Many times, these agreements give the custodian of the shares the right to loan them out, rather than the shareholder. 

 

It is important to note that securing a short locate that allows you to short a stock has a certain time frame associated with it. If the short locate is secured from the Easy-to-Borrow list or if the broker secures it on the client’s behalf, the locate will be valid for the full business day and can be shorted, covered, and shorted again the same day as long as it is not considered Hard-to-Borrow or Threshhold. If it is considered either of these things, it would only be good for a single trade. Therefore, if an investor or trader shorted the Hard-to-Borrow or Threshold shares and then covered them the same day, they would not be able to short them again without first securing a new locate for the shares.

With the distinction between Easy-to-Borrow, Hard-to-Borrow, and Threshold designations, securing a valid short locate can be harder for some company stock than others. Typically, the large companies which have issued a large number of shares are more likely to be easy for your broker to secure a valid short locate.  On the other side of this equation, smaller companies which have issued fewer shares and have smaller capitalizations (small cap, mid cap) will likely be harder for your broker to secure a valid short locate. This highlights the importance of picking the right broker for your strategy. Not all brokers will put in the time and effort required to find some of the less-available short locates which would, in turn, limit the opportunities available to an investor or trader looking to employ a short selling strategy.

 

However, it would be irresponsible to discuss short selling without discussing risk. Why? Because there is unlimited risk associated with short selling. Yes, unlimited. To calculate risk, you have to consider the idea that a stock has no ceiling regarding how far the price can rise. Since a short seller profits if the price of the security falls, they also lose money when the price rises. Since there is no limit to how high a stock price can rise, there is no limit to the risk involved. 

 

There are some lesser known risks to short selling as well. For one, if the stock you are short pays a dividend, and you are short on the record date, you will be responsible for paying the dividend out of your account. Another risk involved is if the company’s stock halts trading while you are short, you will not be able to close your short position. This ties up the capital required for the trade until the stock un-halts. If the stock is halted for a number of days, not only will you be unable to access the capital from the position, you will also still be responsible for any fees related to the short position even though you cannot close the position. 

 

Considering fees is essential in trading. The primary fee associated with short selling is called short interest. Simply put, short interest is the annual interest rate you will pay to hold your short position. The short interest rate fluctuates daily and is primarily based on supply and demand. Though this fee is an annual rate, it is charged daily (including on weekends). 

 

Because the short interest rate is based on supply and demand, it can fluctuate rapidly and considerably. Further, the fee is only applied to settled short shares. Taken together, the short interest rate can change daily at a rapid pace by a large amount and is applied only to settled shares. This means there is no way for you to definitively know what the short interest fee will be when your short shares settle and the fee begins to accrue. Certainly, this risk must be considered when an investor or trader evaluates whether or not to establish a new short position.

 

Another fee associated with short selling is called a locate fee or upfront locate fee. This fee is also primarily based on supply and demand and will fluctuate throughout the trading day. The upfront locate fee is a per-share fee which will apply to any shares an investor or trader locates. There is some silver lining in that, unlike the short interest rate, this rate will be known to the investor or trader at the time they agree to the position so they will know the cost prior to entering the trade.

 

Some brokers will take the upfront locate fee a step further and add a locate multiplier to the fee if an investor or trader chooses to hold the short position overnight. This locate multiplier can be one, two, three, or even four times the original fee. This locate multiplier can add considerable cost to a short trade and should be given high consideration by any investor or trader looking to employ a short selling strategy.

 

In closing, short selling is a strategy which aims to profit from the decline of a stock price. Unlike a typical long only strategy, short selling involves the consideration of multiple factors. Given these and other considerations, short selling is not suitable for all investors or traders, and any investor or trader thinking about deploying this strategy should carefully consider their own financial situation, risk tolerances, investment objectives, and any other relevant factors before making the decision to short sell. 

 

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