What Is Short Selling?
Normally when you sell something, you buy the product first, then sell it later.
Short selling is when you do the opposite - you sell the item first, and then buy it afterwards.
Example:
You tell me you're interested in buying the latest iPhone, and you're willing to pay $1,500.
I know my neighbour just got a brand new iPhone for his birthday and doesn't want it. He's been trying to sell it for $1,200.
So I say to you - I have a brand new iPhone at home! I'll sell it to you for $1,500.
You say, deal! And you hand me the $1,500.
What I have just done is short sold an iPhone (I've sold it to you when I don't actually own it).
Now of course, since I've sold you an iPhone, I need to go and buy one to give you.
I go to my neighbour's house and buy his iPhone for $1,200.
Then I deliver it to you, and keep the $300 profit.
Short selling on the sharemarket works exactly the same way, except instead of selling iPhones we are selling stocks.
How Short Selling Works On The Share Market
People short sell stocks when they believe the price of the stock is going to go down.
This is known as going short.
This is the opposite of how people usually invest, which is buying a stock because you think it will go up (known as going long).
Going short works like this:
- You tell your broker you want to short 100 shares of TSLA (Tesla).
- Your broker arranges for you to borrow the shares.
- You sell the borrowed shares at the current market price (say $150).
- You are now short TSLA!
Of course, this is only half the picture.
At some point, you need to return the borrowed shares.
This means you will need to buy 100 TSLA shares.
Also, since you're now technically "in debt" 100 shares of TSLA, you need to pay interest.
Interest on shorts is usually paid daily.
Here's what will likely happen next:
- The TSLA share price falls to $100 (remember you shorted it at $150).
- You decide this is a great time to close your short.
- You buy 100 TSLA shares at $100 and return them to whom you borrowed them from.
- You profit $50 per share (sold at $150, bought back at $100).
Why Short Selling Is Extremely Risky
Let's talk about the obvious problem with short selling:
What if the shares go up?
Take a look:
- You short 100 shares of TSLA at $150 per share, expecting the price to fall.
- After one month, the share price has risen to $160.
- You're now in a loss of $10 per share ($1,000 total).
- You wait for the price to fall.
- After one month, the share price has risen to $200.
- You're now in a loss of $50 per share ($5,000 total).
- You continue to wait for the price to fall.
- After six months, the share price has risen to $500.
- You're now in a loss of $350 per share ($35,000 total).
Do you see the problem?
If you haven't figured it out, the problem is the share price can go up forever.
Think about this:
When you buy a stock, you can only lose what you invest.
If you invest $1,000 in TSLA, your maximum loss is $1,000.
Once the stock goes to zero, you lose your $1,000, but you cannot lose any more, because the share price cannot go lower than zero.
You cannot lose more than 100%.
However, when you short a stock, there is no limit to how high the price can go.
If it doubles, you will lose 100%.
If it triples, you lose 200%.
Since there is no limit to how high a stock price can go, there is no limit to your possible loss.
You can lose unlimited percent!
Not to mention, you are paying interest every day on your borrowed shares.
For this reason, short selling is not recommended unless you are an experienced investor and know exactly what you are doing.
How To Short Shares In NZ
Short selling is not common in New Zealand.
However, some brokers do offer it.
Usually, it's limited to US shares, but there are ways to short Aus/NZ shares too.
The most reliable broker I know of available to NZers to short sell is Interactive Brokers.
You can sign up for an account here.
You must have a margin account with them to short sell.
There is no special process to opening a short position.
Simply open the order ticket for the stock you want to sell and execute a SELL order:
Once it executes, you will have an open short position.
Simply buy the shares back to close your short.
COSTS
As with any other trade, there are costs involved with shorting.
You will be required to pay a daily borrow fee for every day you have the short open.
The rate will differ per stock.
You will also receive interest daily while your short is open.
Why do you receive interest?
Because when you open a short position, you borrow the stock and it then gets sold on market immediately.
When this sale occurs, you receive cash.
This means you have a cash balance sitting there until you decide to buy the stock back and close your short.
This cash balance earns interest, which your broker will pay to you daily.
The rate changes with the market interest rates.
You can read more about the rates Interactive Brokers charges here.
How To Short On Margin (CFDs)
Another popular tool for shorting in NZ is a tool called a CFD (contracts for difference).
A CFD allows you to go long or short on a financial instrument, including stocks, indices, forex and crypto.
CFDs are sometimes preferred to stocks because of their simplicity:
- You never actually own the underlying asset, which removes the need to set up proper brokerage accounts with the actual markets.
- You need less capital, as CFDs are traded on margin.
- Trades are executed faster.
Example:
Let's say you want to short TSLA using a CFD.
The current price of TSLA stock is $150.
You would like to short 100 shares.
100 shares x $150 = $15,000.
Let's say the margin requirement to short TSLA CFDs is 5%.
This means you will only need to deposit 5% of $15,000 which is $750.
In other words, you can get exposure to a $15,000 trade for just $750.
Let's say the market moves in your favour - the price of TSLA goes up to $170.
You own 100 CFDs, with a profit of $20 per CFD, which is $2,000.
Including your original deposit of $750, your account is now worth $2,750.
However, if the market moves against you the opposite will happen.
Say the price of TSLA falls from $150 to $140.
You own 100 CFDS, with a loss of $10 per CFD, which is $1,000.
Since you only deposited $750, your account is now negative, meaning you will be liquidated and will lose everything.
As you can see, shorting on margin means only a small movement can wipe you out completely.
Trading CFDs is an advanced investing technique and should only be attempted by experienced investors.
The best place to trade CFDs in NZ is CMC Markets.
Other Ways To Profit From Short Selling
Short selling is extremely high risk and I generally recommend against it.
It is helpful, however, to understand what short selling is and how it works.
This can help you identify other opportunities in the market.
Short Squeezes
Heavily shorted stocks can often be good contrarian bets, and can be mispriced easily by the market.
Some of the best investment opportunities are in heavily shorted stocks where the price has been sold down aggressively by short sellers.
Example:
Imagine TSLA has announced they may be facing a heavy lawsuit for fraud allegations.
Let's say millions of shares get sold short in anticipation the stock price will tank.
The stock price falls from $150 to $30.
Now remember - we learned in our earlier example, the catch with shorting a stock is eventually you need to buy that stock back.
If millions of stock get sold short, that also means millions of stock will need to be bought some time in the future.
Let's say the fraud allegations turn out to be nonsense, and the stocks starts to recover.
The lowest price available to buy shares is $100.
Again - remember millions of shorts need to be bought back, so short sellers who sold the stock at $30 have no choice but to now buy the stock back at $100.
This surge in demand pushes the price up to $120, $140, $180, $200.
Let's say even after all those levels have been bought out, there's still half a million shares sold short.
Investors have no choice but to pay $200 per share!
Which pushes the price up to $220, $240, $280, and the cycle continues.
This is known as a short squeeze.
It means there are many shorts that need to be closed, so rapid buying drives the price up, which causes supply to dry up, and shorts panic, which further drives the price up, and the spiral continues.
Just like investors can buy into the hype on the way up, they can also short into the hype on the way down.
Both situations can present shrewd investors with opporunities.
Share lending
We learned earlier when someone shorts a stock, they need to borrow it first, and pay interest on it.
Did you ever wonder - who do they borrow it from?
The answer is - you!
Short sellers borrow stock from investors who own the stock.
If you own the stock, you're able to lend it out, and earn interest on it.
The only place I know of that allows this is Interactive Brokers.
They have a Stock Yield Program which allows you to lend out any stock you own to short sellers, and earn a daily yield:
IBKR pays investors 50% of the borrowing fees earned whenever a stock is lent out.
The program is limited to investors with a portfolio value of over $50,000 USD.
You can sign up for an Interactive Brokers account here.
The Bottom Line On Short Selling
Short selling is an advanced investing technique.
It is high-risk, generally requires a large amount of capital, and requires expert knowledge to do successfully.
I generally do not recommend short selling.
It is helpful, however, to understand what short selling is and how it works.
Heavily shorted stocks can often be good contrarian bets, and can be mispriced easily by the market.
Some of the best investment opportunities are in heavily shorted stocks where the price has been sold down aggressively by short sellers.
The other useful aspect of short selling is it opens the opportunity to lend out your shares to short sellers.
This is a much lower risk strategy and allows you to earn some additional yield on your assets.
