What is short selling?
Looking for a short selling definition? It’s a way of trying to make a profit from securities going down in value. You borrow securities to sell at their current price, but you don't pay for them until prices have gone down so you can pocket the difference. You'll make losses if prices go up. This strategy is also called 'going short', 'selling short' or 'shorting'.
Where have you heard about short selling?
Short selling stock shas been around since stock markets first emerged in the Dutch Republic in the 1600s. Throughout history, short sellers have been blamed for failures in the world's financial markets, and some company executives have accused them of driving down their company's stock prices. The US restricted short selling as a result of the events leading up to the Great Depression. Short selling stocks got a bad name after the 2008 financial crash, as widespread short selling was thought to have influenced big falls in stock value. As a result, some countries introduced temporary short selling bans. But the practice is still popular with traders.
What you need to know about short selling…
Short selling is most often done with instruments traded in public securities, futures or currency markets. You can short sell stocks, exchange traded funds, forex, commodity futures of all types, and bonds.
Short selling is arranged through a broker, who loans you shares to sell at their current value, though you don't buy them until you 'close' your position – by which time you hope the price will have come down. The difference between what you sold them for and what you ended up paying for them is your profit or loss – excluding commissions and interest.As the risk of loss on a short sale is theoretically infinite, short selling is only recommended for experienced traders who are familiar with its risks.
Investors might 'go short' as part of a speculation strategy. They predict that the price of a security will go down, so they sell short to try and profit from this predicted price movement. More risk averse investors may use short selling as part of a hedging strategy – they short a security to offset some of the risks of a long position. They 'go long' in the belief that the price of a security will rise, but if it goes down instead, the gains from their short position can mitigate their losses. This can be an expensive strategy, though, and it doesn't eliminate basic risk.
In order to short sell you'll need an account with a broker, and that typically involves some margin which adds to the risk as you'll be paying interest on this. The investor then borrows the stock from the broker dealer, who lends the stock from the securities that he holds or are in his custody on behalf of his clients. Some big investors owning their own stocks will lend directly in the market. There are two types of loans:
- Call loans - which the lender can terminate at any time. They’re the most common form of loan
- Term loans - which are provided for a specific period, for example one month
The loans are for a given number of stocks rather than a particular value. They are secured loans, because when shares are borrowed, cash or another security is pledged as collateral.
Borrow cost is the fee paid to a securities lender for borrowing the stock or other security. The cost of borrowing the stock is usually negligible compared to fees paid and interest accrued on the margin account. A typical fee for a stock loan is less than 1% per annum. But at times of short supply, when many investors are shorting a stock, the borrow cost can become significant. In one extreme example, in February 2001 the borrow costfor Krispy Kreme stock reached an annualized 55%, indicating that a short seller would have to pay the lender more than half the price of the stock over the course of the year.
It’s also important to remember that although the stock is borrowed by an investor, the lender still gets the dividends. So, when returning the stock, the investor must pay the fee plus any dividend received.
Buying on margin – a related but different practice – is borrowing money from a broker to purchase stock. Margin trading allows you to buy more stock than you'd be able to normally. So, with margin buying you borrow money to buy shares, whereas in short selling you borrow shares to sell later.
Short interest and short interest ratio (SIR) are two metrics that are used to track how heavily a stock has been sold short:
- Short interest is the total number of shares sold short as a percentage of the company’s total shares outstanding
- SIR is the total number of shares sold short divided by the stock’s average daily trading volume
A stock that has very high short interestand SIR could be at risk of a ‘short squeeze’ – a situation in which a heavily shorted stock moves sharply higher, forcing more short sellers to close out their short positions and adding to upward pressure on the stock. A short squeeze – and resulting loss – is a common risk faced by short sellers.
Days to cover
Days to cover is a measure of a company's issued shares that are currently shorted, expressed as the number of days required to close out all of the short positions. It’s calculated by taking the number of shares that are currently shorted and dividing that by the average daily share volume. For instance, if a company has average daily volume of 2 million shares and 4 million shares are currently short sold, the shares have a cover rate of 2 days (4m/2m).
Short selling – reputation and regulation
Short selling stocks can be a controversial practice, with short sellers often depicted as ruthless operators who are bent on destroying companies. But there’s a good case to be made that short selling provides liquidity to markets, and stops stocks from inflating to unjustifiably high levels through over-optimism or hype. Abusive short-selling practices such as bear raids and rumour-mongering to drive a stock lower are illegal, but properly executed short selling can be a good strategy for portfolio risk management.
The UK’s Financial Conduct Authority has regulated short selling and certain aspects of credit default swaps since November 2012, under the EU’s Short Selling Regulation (SSR). The SSR applies to people undertaking short selling of shares, sovereign debt, sovereign CDS and related instruments that are admitted to trading or traded on a trading venue in the European Economic Area – unless they are primarily traded on a third country venue.
The SSR requires holders of net short positions in shares or sovereign debt to make notifications when certain thresholds have been breached. The regulation also sets out restrictions on investors entering into uncovered short positions in shares or sovereign debt.
The SSR gives powers to domestic regulatory authorities – which in the UK means the Financial Conduct Authority – to suspend short selling or limit transactions when the price of various instruments (including shares, sovereign and corporate bonds, and ETFs) fall by set percentage amounts from the previous day’s closing price.
In the US, an ‘uptick rule’ was introduced in 1937, which allowed short selling to take place only on an uptick from the stock's most recent sale. In 2007, the Securities and Exchange Commission rescinded the uptick rule, and short sellers took advantage of their new freedoms in the next stock market crash in 2008.
Since then the SEC has revised the rule again, imposing the uptick rule on certain stocks when the price falls more than 10% from the previous day's close. So short selling is often under the spotlight – and the regulatory stance can change according to the political fashions of the day.
Find out more about short selling…
If you want to explore the subject further, you’ll find definitions for many related terms such as long position, hedge and margin in our comprehensive glossary.
The Financial Conduct Authority’s website gives full details of the regulator’s oversight of short selling.