Short Sale: Definition, Example, Risks, and Margin Requirements

What Is a Short Sale?

A short sale is the sale of an asset, such as a bond or stock, that the seller does not own. It is generally a transaction in which an investor borrows a security from a broker, and then sells it in anticipation of a price decline. The seller is then required to return an equal number of shares at some point in the future.

The assumption behind a short sale is that, if the price declines, the seller can buy the security back at the lower price and return it to the broker. In contrast, a seller in a long position owns the security or stock.

Understanding Short Sales

A short sale is a transaction in which the seller does not actually own the stock that is being sold. Instead, it is borrowed from the broker-dealer through which they are placing the sell order. The seller must then buy back the stock at some point in the future. Short sales are margin transactions, and their equity reserve requirements are more stringent than for purchases.

Brokers borrow the shares for short sale transactions from custody banks and fund management companies, which lend them as a revenue stream. Firms that provide for securities lending include Charles Schwab and Fidelity Investments.

The main advantage of a short sale is that it allows traders to profit from a drop in price. Short sellers aim to sell shares while the price is high, and then buy them later after the price has dropped.

Short sales are considered risky because if the stock price rises instead of declines, there is theoretically no limit to the investor's possible loss. As a result, most experienced short sellers will use a stop-loss order, so that if the stock price begins to rise, the short sale will be automatically covered with only a small loss. Be aware, however, that the stop-loss triggers a market order with no guaranteed price. This can be a risky strategy for volatile or illiquid stocks.

Short sellers can buy the borrowed shares and return them to the broker any time before they're due. Returning the shares shields the short seller from any further price increases or decreases the stock may experience.

Short Sale Margin Requirements

Short sales allow for leveraged profits because these trades are always placed on margin, which means that the full amount of the trade does not have to be paid for. Therefore, the entire gain realized from a short sale can be much larger than the available equity in an investor's account would otherwise permit.

The margin rule requirements for short sales dictate that 150% of the value of the shares shorted needs to be initially held in the account. Therefore, if the value of the shares shorted is $25,000, the initial margin requirement would be $37,500. This prevents the proceeds from the sale from being used to purchase other shares before the borrowed shares are returned.

However, since this includes the $25,000 from the short sale, the investor is only putting up 50%, or $12,500.

Short Sale Risks

Short selling has many risks that make it unsuitable for a novice investor.

Unlimited Losses

Short selling limits maximum gains while potentially exposing the investor to unlimited losses. A stock can only fall to zero, resulting in a 100% loss for a long investor, but there is no limit to how high a stock can theoretically go. A short seller who has not covered their position with a stop-loss buyback order can suffer tremendous losses if the stock price rises instead of falls.

For example, consider a company that becomes embroiled in a scandal when its stock is trading at $70 per share. An investor sees an opportunity to make a quick profit and sells the stock short at $65.

But then the company is able to quickly exonerate itself from the accusations by coming up with tangible proof to the contrary. The stock price quickly rises to $80 a share, leaving the investor with a loss of $15 per share for the moment. If the stock continues to rise, so do the investor's losses.  

Significant Costs

Short selling also involves significant expenses. These include the costs of:

• Borrowing the bond or stock security to sell
• Interest payable on the margin account that holds the stock
• Trading commissions

Market Efficiency

Another major obstacle that short sellers must overcome is market efficiency. Markets have historically moved in an upward trend over time, which works against profiting from broad market declines in any long-term sense.

Furthermore, the overall efficiency of the markets often builds the effect of any kind of bad news about a company into its current price. For instance, if a company is expected to have a bad earnings report, in most cases, the price will have already dropped by the time earnings are announced.

Therefore, to make a profit, short sellers must anticipate a drop in a stock's price before the market analyzes its cause.

Squeezes and Buy-ins

Short sellers also need to consider the risk of short squeezes and buy-ins.

• Short squeeze: When a heavily shorted stock moves sharply higher, which "squeezes" more short sellers out of their positions and drives the price of the stock higher
• Buy-in: When a broker closes short positions in a difficult-to-borrow stock whose lenders want it back

Regulatory Restrictions

Finally, regulatory risks arise with bans on short sales in a specific sector or in the broad market to avoid panic and selling pressures.

To be successful, short sellers must find companies that are fundamentally misunderstood by the market (e.g., Enron and WorldCom). For example, a company that is not disclosing its current financial condition can be an ideal target for a short seller.

While short sales can be profitable under the right circumstances, they should be approached carefully by experienced investors who have done their homework on the company they are shorting. Both fundamental and technical analysis can be useful tools in determining when it is appropriate to sell short.

Criticism of Short Sales

Because it can damage a company's stock price, short sales have many critics, including companies that have been shorted.

Legendary investor Warren Buffett welcomes short sellers. "The more shorts, the better, because they have to buy the stock later on," he is reported to have said. According to him, short sellers are necessary correctives who "sniff out" wrongdoing or problematic companies in the market.

Example of a Short Sale

Suppose an investor borrows 1,000 shares at $25 each, or $25,000. Let's say the shares fall to $20 and the investor closes the position. To close the position, the investor needs to purchase 1,000 shares at $20 each, or $20,000. The investor captures the difference between the amount they receive from the short sale and the amount they paid to close the position, or $5,000.

Short Sale in Real Estate

In real estate, a short sale is the sale of real estate in which the net proceeds are less than the mortgage owed or the total amount of lien debts that secure the property. In a short sale, the sale is executed when the mortgagee or lienholder accepts an amount less than what is owed and when the sale is an arm's length transaction. Although not the most favorable transaction for buyers and lenders, it is preferred over foreclosure.

The Bottom Line

In a short sale, an investor borrows stocks to sell at one price with the intention of repurchasing them at a lower price and pocketing the difference.

Short selling is a risky strategy, as losses are magnified while gains are limited. Short selling should only be done by experienced investors who understand the risks of this trading strategy.