How to Short Stocks?

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Being short is used in the sense of lacking something in finance. You are considered short an asset or security when you would benefit from a fall in the price of that asset or security. The antonym of short is long. Being long refers to the situation where you would benefit from a rise in the price of a security. Thus, short-selling means selling what you do not own.

Being short can only be defined with respect to a fungible asset. Fungible assets are classes of assets that are interchangeable. For example,

1. Royal Bank of Canada, RY, has close to 1.4 billion shares outstanding. When you own an RBC share, it does not matter which one of those shares you own, as they are all equivalent.
2. The Canadian dollar is fungible, so all $50 bills and all combinations of other bills and coins adding up to the same amount of $50 are equivalent to each other.
3. Any ounce of pure gold is identical to any other ounce of pure gold; it does not matter where it is mined from or who has mined it.

By borrowing and short-selling a fungible asset, you can become physically short of it, whether it is a precious metal, a stock, or a bond. By borrowing and short selling, you have opened a short position. Later, when you buy back that asset and return it to the owner, you have closed your short position. Thus for a short trade, the steps of the trade are reversed compared to the regular long trade, where you buy the security and later sell it.

Shorting a stock is a negative income strategy as if a dividend is paid while shorting the stock; you need to compensate your stock lender for that dividend. Theoretically, zero is the lower bound for a security's price, while there is no upper bound for a security’s price. Thus in a long trade, the potential for loss is limited to the cost of the security, while the potential gain is unlimited. On the contrary, in a short trade, the potential for loss is unlimited while the profit potential is limited.

As you can see by now, odds are set against those who are shorting stocks. You should short a stock only if you have a high conviction in the demise of that stock over the short term. As a retail investor, you would be relying on your stock broker to help you borrow the stock to short. The only thing you do is give a sell order.

When you do not own the stock you are selling, the broker would understand that this is a short sale. The broker should only execute your sell order if they are reasonably confident they can deliver the security for settlement in two business days. If any of their customers have those stocks in a margin account, they can lend those stocks to you.

A margin account is an account in which a customer's assets are used as collateral, allowing the customer to borrow money (and securities) from their broker. All customers' assets are registered under the broker's name, and retail customers are beneficial owners of those assets. Meaning that they own their securities even though it is not registered under their name.

If a broker wants to lend securities from a customer’s cash account, it should seek permission to do so as those securities are with the broker for safekeeping. In the case of margin accounts, securities are with the broker as collateral, and the broker can lend them on its own. Just as borrowing money from a broker (or any financial institution) entails paying interest, borrowing securities entails paying a borrow fee or a stock loan fee. The borrowing fee is often expressed as a percentage of the security’s price.

Large institutions like pension funds, mutual fund managers, ETF sponsors and the like are often willing to lend their shares for some extra income. Brokers would go to such holders if their relatively large customers need to borrow a stock. The borrowing fee is a function of supply and demand. The borrow fee changes daily depending on the ease or difficulty of locating that stock. Borrow fees are often small compared with changes in stock prices, but in cases where many investors have been shorting a stock and there have not been many lenders, borrow fees above 60% per year have occurred.

It is natural to think that a company with accounting irregularities is providing the best stock to short. Yet when news of such irregularities gets to regulators, they might halt trading in such stocks for long periods. In such cases, short sellers would be paying a borrow fee for an extended period of time when the stock price is frozen.

Just as borrowing money to buy stocks requires collateral, borrowing shares to short them would require collateral. The amount of this collateral would depend on the stock and your broker, but it is always greater than the stock price. Proceeds of the short sale provide part of this collateral, while you must provide the rest either as cash or as marginable securities. Marginable securities are securities that can be bought on margin.

After selling a stock short, if the stock price decreases, the collateral needed for your short position would decrease, and your account excess margin would increase. On the contrary, if the stock price increases, the amount of collateral you need for this position increases, decreasing your account's excess margin. You will receive a margin call if the price move is large enough to bring your account into a margin deficit.

A margin call is when your broker asks you to send money to your margin account. If you can’t or do not send cash fast enough to your margin account, the broker will buy back the shorted stock. Some brokers, like Interactive Brokers, might not give you time to deposit some money into your account and might close your position immediately when a margin deficit occurs.

A similar situation can occur in a long trade if you have bought stocks on margin and the price decreases. So any time you use leverage, that is, either buying with borrowed money or selling borrowed securities, you risk being forced out of your position. You might be right about a stock you have shorted being overvalued or a stock you have bought on margin being undervalued but be forced to close your position prematurely by taking a significant loss.

John Maynard Keynes, the famous British economist, was a successful investor until he lost most of his wealth in the 1929 stock market crash. He has a famous quote, “the market can stay irrational longer than you can stay liquid.”

The Investment Industry Regulatory Organization of Canada (IIROC) regulates brokers, dealers and exchanges in Canada. IIROC twice each month publishes a short sale trading statistics report and a consolidated short position report. The first report informs the public about the portion of each securities trade being short sales. In comparison, the second report informs the public of the aggregate number of short positions in each security.

According to the most recent report by IIROC, the most shorted security on Canadian markets is Ontario green bonds maturing in February 2027, with close to 104 million bonds sold short. This suggests many expect rising interest rates and thus a fall in bond prices.

The second and third most shorted securities on Canadian markets are BlackRock's TSX60 index ETF with ticker symbol XIU and Enbridge Inc. Short interest in TSX 60 suggests an expectation for price decline in the Canadian market either because of rising interest rates discounting future cash flows from stocks or because of a pending recession bringing down corporate earnings.

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Considering short positions taken by other investors is essential for gauging sentiment as well as assessing risk. On the one hand, it is an indicator of sentiment in the market. On the other hand, seeing a significant short interest tells anyone who wants to take a long position that there is likely a compelling case to be made against the stock, and they are better to think through their reasoning for going long.

Cenovus Energy and Canadian Natural Resources have the largest number of short-sale trades. These are both Canadian Oil and Gas companies. Some investors expect a drop in Canadian Oil and Gas companies' share prices.

Investor A shorted 100 shares of the Toronto-Dominion bank on for $92 per share. They bought back these shares onfor $84 per share. Investor A paid a $10 commission for each trade and an average 5% stock loan fee. After closing their position, Investor A felt they had left too much money on the table and decided to repeat their success. So they sold 100 TD shares on for $83 and repurchased shares for $85. The tally for these speculations is in the table below.

To answer this question, it is tough to investigate 1500 companies listed on Toronto Stock Exchange. So we consider the S&P TSX index as an average of Canadian listed companies.

Over the past five years, comparing each business day closing price to the last business day closing price, the index rose 706 days and fell 548 days. In other words, you would have done better on 56% of days being long, while you would have been better off short on 44%. But this comparison is unfair because the S&P TSX index comprises 250 of the most successful companies in Canada. Toronto stock exchange is constantly listing successful growing companies while delisting failing companies. Among these listed companies, more successful ones become members of the index while the weaker ones are left outside the index.

Inverse ETF

There are ways to benefit from a price decline other than establishing a physical short position. The easiest way to benefit from a price decline is to buy an inverse ETF. With an inverse ETF, you do not need a margin account and limit your downside risk.

Options

Another option for benefiting from a price decline is using options. There are two types of options: call options and put options. A call option gives you the right but not the obligation to buy an asset at a specified price called the strike price by a selected date called the expiration date.

Similarly, a put option gives you the right but not the obligation to sell an asset at the strike price by the expiration date. Buying put options would benefit you from a falling price; similarly, selling a call option would allow you to benefit from a falling price.

A synthetic short position can be made by buying at the money put and selling at the money call option.

Future Contracts

As the name suggests, a futures contract is an obligation by a seller to deliver an asset with specified quality and quantity at a specified date in exchange for a specified price. At the same time, the buyer must receive the asset with specified quality and quantity and pay the specified price for it.

Futures contracts are commonly used for commodities, precious metals and financial instruments. Commodities with active futures contracts include crude oil, natural gas, wheat, corn, copper, and aluminum. Selling a futures contract results in a short position, while buying a futures contract results in a long position. The margin requirement for futures contracts is typically 3%-12% of the contract's notional value. So when trading futures contracts, you leverage your deposit between 8 to 30 times. A multiple between 8 and 30 will amplify any profit or loss. This shows the grave risk involved in trading futures contracts for speculation.

Shorting can be done either for speculation on falling prices or hedging purposes. Hedging is any action that reduces the risk from a specific factor. For example, if you sell put options on RY, you face the risk of losing money if the price of RY falls. You can hedge this risk by shorting RY.

An airline sells plane tickets months in advance; it risks losing money if jet fuel prices rise. It can hedge this risk by buying (taking a long position in) futures contracts for jet fuel. A wheat farmer faces the risk of losing money if wheat prices fall significantly by the harvest time. They can hedge this risk by selling (taking a short position in) futures contracts for wheat. An activist investor buys a stake in a company and pressures the company to implement changes which would result in an improved share price. They risk losing money if the market as a whole decline, even if their strategy is successfully implemented. They might choose to hedge this risk by shorting a market index.

If you order various investment strategies based on their risk profile, you would have savings accounts and GIC investments on the low-risk end of the spectrum and short selling on the high-risk end of the spectrum while buying stocks would be in between. Some of the risks associated with short-selling stocks are explained below.

1. If you make a mistake, there is no limit to losses. For this reason, some traders use stop-loss orders on their short positions. These orders instruct the broker to buy back the stock if its price exceeds the loss they are willing to absorb.
2. There is no limit to the borrowing fee if the stock becomes hard to borrow. Also if the investor who has lent his shares wants to sell them and your broker cannot find other shares to borrow for you, you would have to buy back and close your position.
3. A short squeeze. If a stock is heavily shorted, it can become dangerous for short sellers. A rise in the stock price can trigger stop loss orders, which can cause a further rise in the stock price. This price rise may cause brokers to issue margin calls for other short sellers, potentially forcing them to repurchase the stock. So when a stock is heavily shorted, a danger exists for a self-feeding loop of price rises which might wipe out many short seller portfolios. When short interest in a stock is high, some traders might buy that stock to trigger a short squeeze and sell their shares to short sellers for a fast profit. To see what might happen in a short squeeze, consider the Volkswagen short squeeze in October-November 2008.

Two metrics, short interest and days to cover ratio, are often considered to gauge the sentiment about a stock and assess the risk of a short-squeeze. These metrics are defined as

Short sales can only be achieved in a margin account as there cannot be any borrowing nor leverage in a cash account. Thus, a physical short trade cannot be made under a tax shelter like a TFSA or an RRSP. Profit realized when you buy back the borrowed shares at a lower price is a capital gain and taxed as capital gains.