How Short Selling Works

"The Big Short" is highly popular when it comes to investing topics. 

It features a star-studded cast and tells the true story of three groups of people who bet against or "short" the housing market, earning billions of dollars shortly before the 2008 real estate crisis. 

While the movie portrays the protagonists making significant profits, it's important to understand how shorting actually works. 

In the movie, the characters enter into swap agreements, which are derivatives made with banks. 

However, for individual investors, short positions typically involve betting against specific stocks, which is relatively straightforward. 

It's crucial to note that shorting carries substantial risks and differs from standard investing in several ways. 

When shorting, you may incur additional expenses that are not typically associated with traditional investing. 

Moreover, shorting offers a lopsided payoff structure, where your potential gains are limited, but the potential losses are uncapped. 

This means that in theory, you could potentially lose an unlimited amount of money. 

Therefore, it's essential to thoroughly understand the strategy and the risks involved before deciding to short something.

Shorting

Shorting, also known as short selling, is a trading strategy where an investor sells a security with the intention of buying it back in the future at a lower price. 

It is essentially the opposite approach to a traditional long position, where investors buy a security with the expectation that its price will increase. 

The underlying principle of both strategies is to buy low and sell high, but shorting reverses the order. When an investor goes short on a stock, they are selling it upfront, anticipating that its price will decrease, so they can buy it back cheaper later. 

Shorting a stock is more complex than going long, so let's use an example to explain the strategy and the risks involved. 

Example (i)

Imagine there are two investors in Vanilla Investor Co. The stock of the company currently trades at $100. 

Now, investor A decides to buy 100 shares, investing $10,000. 

On the other hand, Investor B chooses to short 100 shares, effectively selling $10,000 worth of the investment. 

Now, you might wonder how someone can sell a stock they don't own. In many cases, the process involves borrowing the security from a broker and then selling it, using the proceeds from the sale. 

It's important to note that the money generated from the sale doesn't truly belong to the short seller since they sold someone else's stock. 

However, when they eventually buy back the security, known as covering the short, they can return the borrowed stock and keep the remaining money, which constitutes their profit from the trade.

Returning to our example, let's say the stock price of Vanilla Investor Co. drops from $100 to $50. 

In this scenario, Investor A, who bought the stock, would experience a loss of $5,000. 

On the other hand, Investor B, who shorted the stock, would gain $5,000 because they can repurchase the stock at a lower price and retain the remaining proceeds from the initial sale. 

Conversely, if the stock price rises from $100 to $150, Investor A would be up $5,000, while Investor B would incur a loss of $5,000. 

Now, this raises an intriguing question: 

Up until now, Investor B hasn't actually invested any of their own money, so how can they afford to buy back the stock at a higher price than the funds in their account? 

This is where the concept of margins comes into play.

Concept Of Margin

In order to establish a short position, an investor is required to deposit an initial margin, typically around 50%, into their account as a precautionary measure in case the investment loses value. 

In our example, Investor B would have initially contributed $5,000 of their own funds to serve as a buffer for potential losses. 

Additionally, Investor B will be responsible for meeting margin calls, which occur when the margin falls below a certain threshold. 

For instance, if the share price rises to $150, Investor B would receive a margin call to replenish their cash buffer based on the maintenance margin. 

This is necessary because there is no more flexibility in the account to accommodate further losses. 

It's important to note that shorting a position can only be done in a margin account, which comes with its drawbacks. However, it does provide leverage to the investor's potential return, distinguishing it from going long on a position.

To illustrate this further, let's revisit our example. 

Example (ii)

Suppose the share price drops from $100 to $50. 

As a result, Investor A would experience a loss of $5,000, while Investor B would gain $5,000. 

On an absolute basis, these returns are equal. 

However, when considering the impact of margins, the percentage returns differ significantly. 

Investor A has incurred a loss of approximately 50% of their initial investment. 

On the other hand, Investor B, who has only contributed $5,000 of their own funds to the margin account, has effectively gained 100% on their investment. 

This represents double the percentage return of Investor A. Short positions involve borrowing, which amplifies the returns for Investor B. 

However, it's important to note that this amplification works both ways. 

Percentage losses in a short position will be twice as large as they would have been for Investor A. For example, a 50% decline for Investor A would translate to a 100% decline for Investor B. 

Short positions have distinct disadvantages, including unique costs that standard long investors do not encounter. 

For instance, if the borrowed stock pays a dividend, Investor B would be required to pay this dividend amount to their broker. 

This means incurring a cost equivalent to the dividend payment made by the stock.

Cost Of Interest

Short positions also come with the cost of paying interest on the borrowed value of the stock. 

Since you are borrowing and selling someone else's security, it is necessary to compensate them, similar to how you repay a bank with interest on your loan. 

Typically, the interest rate charged for a short position can range from 2.5% to 20%, but it can be higher for "hard to borrow" stocks, highly volatile stocks, or small-cap positions. 

So, shorting a stock can be considerably more expensive than a simple buy-and-hold strategy. 

These expenses, such as interest payments and compensating for dividends received, are generally justified. 

The interest reflects the leverage involved in the short position, and paying out dividends received aligns with the objective of inverting the return of a long position. 

However, there are absolute disadvantages associated with the short strategy that may deter you from attempting to short a stock.

Buy-In Risk & Short Squeeze

One such drawback is the buy-in risk, which involves the possibility that a broker may force you to cover your position prematurely. 

This can happen if the broker needs to return the stock to its original portfolio or if there is a sudden surge in demand for the stock. 

In either case, you may be compelled to close your position at any time. 

This buy-in risk is a significant drawback, especially when dealing with market volatility and waiting for favorable conditions.

In our example, let's consider that investor B is confident that certain factors, such as regulation or technological changes, will cause the stock to crash in two years. 

However, if the stock price surges in the short term, they may be forced to accept a loss, even if their long-term prediction turns out to be correct. 

This situation is known as a "short squeeze," which occurs when a heavily shorted stock experiences a significant price increase. 

Short sellers are compelled to buy back the stock to cover their positions, and if many short sellers do this simultaneously, it can drive up the stock price, making it challenging for you to cover your own position without incurring a loss. 

As you can see, there are several distinct disadvantages associated with shorting a position, which may be reason enough to avoid it. 

However, the biggest risk with short positions lies in their skewed payoff. In comparison to investors taking long positions, those shorting a $100 stock face contrasting risk-reward profiles. 

Example (iii)

On the one hand, investor A can potentially achieve an infinitely high return on their $10,000 investment if the stock price climbs to $200, $300, $400, or even higher. 

On the downside, the maximum loss is limited to the amount invested, $10,000, which would only occur if the stock price plummeted to $0—an extreme outcome.

Now, let's focus on investor B and how the risk-reward dynamic changes for them. 

If the stock price drops to $0, disregarding fees, they can achieve a 200% return since they get to keep the initial $10,000 investment plus the $5,000 in profits from their $5,000 contribution. 

However, if the stock price instead climbs to $200, $300, $400, or even higher, their losses can reach 200%, 400%, 600%, or more. 

This means that the potential losses can exceed the initial investment by a significant margin.

This feature of short selling has had disastrous consequences for some investors.

Due to the substantial risks involved and the fact that short selling goes against the natural upward bias of stocks, many investors prefer to stick with long positions.

- Ivan