From the Financial Toolkit: Short Selling

In the previous blog post I wrote about the mechanics of options to help smooth out and reshape investment volatility.  In this blog post I want to discuss another investment tool:  short selling.

Short selling involves borrowing shares of stock and selling those borrowed shares.  This immediately does two things to your portfolio:  1) It gives you a liability for the shares, 2) It gives cash proceeds from the sale.

An investor, Alice, may choose to short a stock (or ETF) because she expects its price to fall.   She may expect one security  to fall relative to another security.  For instance, if Alice expects AAPL to outperform MSFT over then next six months, she could short MSFT and use the cash proceeds to purchase AAPL.  Even if MSFT goes up, Alice will make money so long as the value of her AAPL holdings go up more.

Suppose things don’t go according to plan for Alice.  For some crazy reason MSFT shares go way up, while AAPL shares remain flat.  As this trend continues, Alice’s portfolio net asset value (NAV) erodes.  This decreases Alice’s margin and increases her portfolios’ leverage.  If the trend continues Alice will eventually receive a margin call and have to cover her short position by buying MSFT stock to close her short position.

There are a few details to be aware of before entering a short position on a security.  The first is determining whether (and how much) stock is currently available for short-sale.  Once you’ve determined that your chosen stock is available for shorting, you should find out the particular terms for borrowing the stock.  For instance, you may forfeit a small percentage of your short-sale proceeds.  Often highly liquid stocks will be cheaper to borrow than less liquid ones.

Once you’ve found an stock with short-availability and an acceptable borrowing rate, you can execute a short-sale.  Since you will have a negative position (say -100 shares) you will pay rather than receive dividends on every share.  See also this helpful explanation of how, where, and why short-shares become available.

That’s the basics of short-selling.  Short-selling provides an alternative way to bet against a stock.  Buying puts is one method, short-selling is another.   Short-selling is allows going long-short… picking winners AND losers.  Short-selling is a tool that opens many investing opportunities and exposure to additional investing risks.

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