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Short Selling Strategies

Short Selling Stocks

Profit on the way down

Short Selling Strategies - Shorting Stocks; picture of an investor figurative character sitting down looking depressed as the stock price shown on the big chart keeps falling lower

Stock investors are continually faced with the prospect of their stocks heading in the wrong direction. When investors buy their stocks, they do so with the intention that the stock's price will increase.

Experienced investors have come to the realization that stock prices do fluctuate quite considerably, but it is when these fluctuations continually head downwards that has investors wondering if there are any tactics that they could use to profit from this decline.

The simple answer is yes and it's called Short Selling. The basic idea is to sell the stock first and then buy it back later at a lower price. Thus the investor has still managed to buy the stock for less than what it was sold for, even though the stock's price actually declined.

The question now is, just exactly how does the investor sell something they do not own?

Short selling stock is the process of borrowing the stock from someone else and actually selling their stock. The person the stock is borrowed from (the stock lender) is effectively given an IOU that the investor will return the borrowed stock at a later date. In return for the privilege, the investor agrees to pay interest to the stock lender and agrees to pay any dividends due to the stock lender. The investor further agrees that the stock lender may at their discretion demand that those shares be returned promptly.

Short selling is the process of borrowing stock

from someone else and selling their stock

There are some issues with short selling that the investor should be aware off. These are as follows:

Short selling considerations:

  • The stock is generally borrowed from another investor, but may be from the broker's own holdings. The shares that can be borrowed are placed into a broker inventory list.
  • Some stocks are permanently restricted from short selling by the U.S. Securities and Exchange Commission (SEC). The SEC may without notice implement a temporary ban on short selling a particular stock (even if the investor has already short sold it), thus forcing the investor to immediately buy the stock back from the market to close out their short position.
  • Even if a stock is permitted to be short sold, there may not be any shares available at the time the investor requires the shares.
  • The investor must pay the stock lender interest and the interest rate is determined by supply and demand. The more demand there is for borrowing that stock, then the higher the interest costs and for some hard to borrow stocks the interest rate can be around 100% per year. For easy to borrow stocks, the interest rates may be well under 1% per year. Hence there is a wide range in interest rates and they change dramatically throughout the year.
  • Any dividends that the stock lender would have received must be paid by the investor short selling the stock. This is an additional cost to the short seller, however stock's do tend to gap down on the ex-dividend day and thus effectively lowering the stock's price to the advantage of the short selling investor.
  • The stock lender may recall their stock at any time and without notice. Typically the broker attempts to re-borrow the stock from the broker inventory list, but there is no guarantee that there will be any stock available at that time. Therefore, the investor's short position may be closed out at a time and price that is not favorable.
  • The investor requires a margin account in order to short sell. Cash accounts and individual retirement accounts (IRA) are restricted from short selling.
  • Should the stock rally, then the investor may have difficulties in buying stock to cover their short position in order to exit their position. This is referred to as a Short Squeeze and can catch investors off guard (Stocks can rally by more than the value of their short position).
  • With buying stocks, the downside risk is limited to the price paid and the upside potential is unlimited. But with short selling, the downside profit potential is limited to a maximum theoretical 100% and the upside loss is unlimited. This makes short selling a high risk tactic unless it is used as a hedging strategy.

Short selling is generally more suited to active investing and is more commonly utilized for short-term investing and trading tactics. Hedge funds and professional traders make good use of short selling which can be quite profitable during bearish market conditions.

Most investors who successfully short sell do not normally short sell in isolation, but rather use short selling in conjunction with other tactics such as spreads, arbitrage and options strategies.

Due to the higher risks and special conditions involved with short selling, it is best left to investors who have the skills and experience to manage this approach to investing. As a general rule, beginner investors who short sell tend to get themselves into a lot of trouble, especially when markets turn bullish again.

Short Interest Strategies

Earn an income from loaning your stock to short sellers

Short Selling Strategies - Short Interest; picture of an investor pointing to glass see through sign button on the screen saying shares in big red letters

Short interest refers to the percentage of stock that is currently sold short for a given stock. Investors use this information to determine the sentiment towards a particular stock by comparing the short interest to the stock's average daily trading volume. Investors short sell the stock when they feel there is sufficient downward pressure on the stock's price.

Short selling occurs when a market participant sells stock that they do not own. In order for them to do this they must first borrow the stock from another market participant who effectively loans their stock to them.

The market participant who loans out the stock is known as the stock lender and the market participant who short sells this stock is known as the stock borrower. Thus the stock lender is effectively given an IOU by the stock borrower that the stock will be returned at a later date. The stock borrower pays a daily interest charge for this and the stock lender typically receives halve and the stock broker receives the other halve as a fee for managing the transaction.

The market participants who loan out stock are usually investors and include institutions especially hedge funds. The incentive for loaning out stock is in receiving the daily interest payment and this style of investing is generally known as stock loan yield investing. The market participants who borrow stock are largely stock traders and hedge funds.

The daily interest charge is usually quoted as an annualized figure and ranges from under 1% to over 100%. This figure is generally referred to as the short interest rate and is determined by supply and demand. The more demand there is from stock borrowers wanting to short sell the stock then the higher the short interest rate will be. Conversely when the supply from stock lenders is high and there is little demand from stock borrowers then the short interest rates drop to low levels.

The speculative investor can maximize the benefits of stock loan yield investing by specifically selecting stocks for their portfolio which pay higher short interest rates. Any of the investing styles can be used to base the purchasing decisions on. Ideally the speculative investor seeking the short interest payments would select fundamentally sound stocks especially investment grade stocks.

Stocks with high short interest are usually stocks where there is some concern over the company's future and the stock price is dropping. This is the usual scenario with value stocks and appropriate stocks are those that are fundamentally sound. Thus these value stocks can also make good stock loan yield investing stocks.

Stocks with high short interest fees usually have

concerns over the company’s future

The short interest rate does however vary significantly over time and even though a stock was originally bought with a high short interest rate, the rate can drop down to low levels as the demand from stock borrowers declines.

Speculative investors find buying investment grade value stocks with high short interest rates appealing as they hold the stock for as long as the short interest rate is high. If the short interest rate drops but the stock is still below its fundamental valuation they simply hold the stock until it trades above its fundamental valuation. Some value traders sell value stocks at a profit target.

Some speculative traders combine short options tactics with value trading together with high short interest rate stocks. Short selling put options pay high premiums when the short interest rate is high. The speculative trader short sells put options with the intention of being assigned and uses this as an alternative method of buying stock. This tactic is also used by speculative investors.

Another tactic used by speculative traders who utilize value trading tactics is to short sell put options on stocks with high short interest rates and use the high option premiums received to buy call options. If stock price goes up they sell the call option for a profit. Should the stock price decline and the short option is assigned, the stock is acquired and then loaned out for the short interest payment.

Any dividends paid by a company are received by the market participant that the stock borrower sold the stock to. However the stock borrower must pay the stock lender the equivalent amount as payment in lieu of the dividend. Thus the stock lender still receives payment for the dividend.

Some market participants are concerned about being long with a stock that has a high short interest as they feel that the stock will simply keep declining. While there are a lot of short sellers driving the stock price down, if the stock rallies then all these short sellers have to cover buy to exit their short positions and this adds a lot of buying to fuel a rally.

When a stock declines, stock holders which are mostly investors can hold onto their positions since they have a long-term view. However, this is not the case with short sellers who are short-term. If the stock rallies, short sellers who are all traders must exit at their stop-loss as they cannot afford to hold onto a losing short position. A stock can rally and never come back to their short entry price.

There are speculative traders who buy financially distressed stocks with good future potential and also have a high short interest rate. This high risk tactic can yield large profits when the company reports on improving financial conditions. This typically causes a rally and all those short sellers are now being stopped out with their stop-loss levels triggered. The additional buying demand this creates can really fuel the rally.

The general tactic of loaning out stocks with high short interest rates is one of the lowest risk strategies, especially when combined with investing strategies. The only real downside to stock lending is the brokers generally have a minimum account size requirement which can be $50,000 or more.

Short Selling Distressed Stocks

These can be profitable - but they are high risk

Short Selling Strategies - Short Selling Distressed Stocks; picture of a financially unhealthy stock with a medical scope on the stock report indicating that the company should be sold by investors

A popular speculative strategy amongst experienced speculative traders is short selling financially distressed stocks. They also attract the attention of technical traders such as swing traders and position traders since these financially distressed stocks are typically in long-term downtrends.

Short selling financially distressed stocks is a very high risk strategy which is not suited to beginner or inexperienced traders. Financially distressed stocks can rally hard, especially when any information is released which indicates that the company may be able to turn around its financial situation. It is extremely important to utilize risk management tactics such as implementing a stop-loss.

The Z-score is a convenient indicator for measuring the probability of a company heading into bankruptcy within two years. Speculative traders search for companies with very low Z-scores especially negative Z-scores as this indicates there is a very high risk of bankruptcy. Other indicators of a financially distressed company are little or negative working capital, lots of prior years' losses and declining tangible book value.

The main reason that these short selling speculative traders look for potential bankruptcy candidates is that these stocks have a fundamental reason for continuing their downtrend and they typically trade as low as a few cents before bankruptcy proceedings begin.

While these stocks can rally hard, they are still typically stuck in long-term downtrends and when the rally fades out (which is usually sooner or later) then the downtrend continues. This is a popular entry point for the speculative short selling trader.

Even fundamentally sound stocks can end up in long-term downtrends at some stage, but the difference with the fundamentally sound stock is that there is a fundamental reason for the stock price to bottom and reverse into a new long-term uptrend. Financially distressed stocks that remain distressed have a fundamental reason to continue downwards.

Even fundamentally sound stocks can be in long-term

downtrends, but they will rally sooner or later

The fundamentally sound stock has the tangible book value which gets in the way of the downtrend. If it becomes too cheap it becomes a takeover target. Thus there is a price floor. This makes them too high a risk for short selling once stock prices drop below the stockholders' equity value.

With a financially distressed stock the tangible book value keeps declining as its debts continue to mount. There is no price floor as the floor keeps dropping lower. This is precisely what the speculative short selling trader is looking for, no price floor other than zero which is basically its bankruptcy value for the common stock. In other words, the short seller is looking for a stock that will most likely head towards a stock price of zero.

In principle this sounds like a good strategy for the speculative trader but there are some catches.

The first catch is that a lot of the good candidates are small-cap stocks which are very thinly traded and some are restricted from short selling. So this alone eliminates a lot of potential candidates as they cannot even be short sold.

The second catch is that even when a financially distressed stock can be short sold, as the stock price continues to drop, a short ban is imposed which means that the stock must be recalled and thus the stock price will never actually reach zero.

The third catch is that even if they can be sold short some of these stocks have a very high short interest which means the short interest fee is very high which adds a considerable cost. So even if a proposed trade were viable, the short interest costs can make the risk-reward unfavorable.

Nevertheless this does not stop speculative traders from short selling these financially distressed stocks. They simply keep short selling until the ban is enforced and capture as much of the price decline as they can.

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