What is shorting a stock?
Investors are familiar with the phrase “buy low and sell high.”
When portfolio managers think a financial security, such as a stock, will rise in value, they can buy the stock and sell it at a later date when the stock price goes up, thus making a profit. Buying a stock in the hopes that it will go up is called entering into a “long position.”
But let’s consider the inverse – selling high and buying low.
If a portfolio manager thinks a stock will fall in value, they can enter into a “short position.” Physical short selling involves borrowing shares, selling the shares in the open market, and buying them back at a later date.
How do you short a stock?
For example, if the current value of XYZ stock is $50 per share and a portfolio manager thinks this stock will fall in value, the manager can borrow a share of XYZ from a broker and sell the share in the open market, thus obtaining an initial inflow of cash.
Since that share was borrowed, the portfolio manager will eventually need to buy back the share to return it to the broker, known as “covering the short”. In our example, the manager had sold the share for $50 dollars; to make a profit, the manager will have to buy it back at a value that is lower than this original value.
Next, XYZ stock could either:
Initially the portfolio manager borrows 1 share for $50.
1. In our first scenario, the stock price declines in value from $50 to $40. If the portfolio manager covers the short at this time, he/she will buy back the share at $40, making a $10 profit (minus borrowing and transaction costs).
2. In our second scenario, the stock price increases in value from $50 to $60. If the portfolio manager covers the short at this time, he/she will buy back the share at $60, resulting in a $10 loss (plus borrowing and transaction costs). Because there is no limit on how much a stock can increase in value, the short position is theoretically subject to unlimited losses.
The ability to short sell allows portfolio managers to capitalize on their negative views as well as their positive ones. The ability to generate profit from short selling depends on the skill and capabilities of the portfolio manager. Short selling is subject to several risks, including but not limited to: risk of loss if the borrowed security increases in value at the time of short coverage, risk that the counterparty demands the return of the borrowed security at an inopportune time, and risk of being forced to cover the short due to an inability to maintain collateral requirements.
