Short selling is another technique you can add to your trading toolbox. That is, if it fits with your risk tolerance and investing style. Short selling provides a sizable opportunity with a hefty dose of risk. We hope this tutorial has enabled you to understand whether it's something you would like to pursue. Let's recap:
The S&P 500 closed at 2,067.56 on November 28, 2014. With the index near all-time highs, let’s say you are concerned about the risk of a potential decline on your investment portfolio, and are looking to hedge about $60,000 of market exposure over the next six months, using the S&P 500 as a proxy.
You have three choices to achieve this objective:
- Initiate a short sale on the SPDR S&P 500 ETF Trust (aka a “spider”), which trades under the symbol SPY. SPY closed at $207.20 on November 28, 2014, so you short 290 units.
- Buy at-the-money protective puts on the SPY. The June 2015 puts with a strike price of $207 closed at $10.25 on November 28, 2014, so a purchase of three contracts (which would have 300 SPY shares as the underlying, since each contract is of 100 units) would involve an outlay of $3,075.
- Buy the ProShares Short S&P 500 ETF, which trades under the symbol SH and closed at $21.78 on November 28, 2014. Hedging $60,000 of market exposure would require you to buy about 2,755 units of SH.
Scenario 1: Let’s say the S&P 500 closes at 1,950 on June 15, 2015. How do the three alternatives stack up?
- Profit on short sale (based on assumed SPY price of $195.50 on June 15, 2015) = ($207.20–$195.50) x 290 = $3,393. Return on investment (assuming no margin) = $3,393 / $60,088 = 5.65%.
- Profit on put position (based on assumed put price of $11.50 on June 15, 2015) = ($11.50–$10.25) x 300 = $375. Return on investment = $375 / $3,075 = 12.20%.
- Profit on short ETF position (based on assumed SH price of $23.25 on June 15, 2015) = ($23.25–$21.78) x 2,755 = $4,050. Return on investment = $4,050 / $60,004 = 6.75%.
Scenario 2: Assume the S&P 500 closes at 2,125 on June 15, 2015.
- Loss on short sale (based on assumed SPY price of $213.00 on June 15, 2015) = (207.20–$213.00) x 290 = - $1,682. Return on investment (assuming no margin) = -$1,682 / $60,088 = -2.80%.
- Loss on put position (based on assumed put price of $0 on June 15, 2015) = ($0–$10.25) x 300 = -$3,075. Return on investment = -100%.
- Loss on short ETF position (based on assumed SH price of $21.00 on June 15, 2015) = ($21.00–$21.78) x 2,755 = -$2,149. Return on investment = -$2,149 / $60,004 = -3.6%.
Note that the above examples only consider gross profit and do not consider costs involved such as commissions, margin interest, etc., which can be significant expenses for short sales.
The actual choice with regard to these three alternatives would depend on a number of factors: the investor’s knowledge and risk tolerance, cash available for putting the hedge in place, length of time for which hedging protection is required, etc. For example:
- If availability of cash were a constraint, puts would be preferable to a short sale or inverse ETF for downside capture.
- As well, if risk were to be capped, puts would again be preferable to a short sale or inverse ETF.
- Sophisticated traders may delve into short selling, but beginners and less experienced investors may be better off with puts and inverse ETFs.
- For a bearish bet on a specific stock, the choice would be between a short sale and a put, depending on the factors discussed earlier.
Let’s recap the main points covered:
- Short selling turns around the conventional investing principle of "buying low" initially and "selling high" later, by seeking to sell high first and buy low later. Short selling makes it possible to sell what one does not own, by borrowing the asset or instrument in question, selling it, and then buying it back (hopefully at a cheaper price) to replace the borrowed asset.
- Short selling can generally only be undertaken in margin accounts. Because of the higher degree of risk involved in short selling, the short seller has to ensure that he or she has always has adequate capital (or “margin”) in the account to hold on to the short position.
- A short sale should be declared as such when placing the order. The trader should also ensure that the stipulated minimum amount of capital is in the margin account prior to making the short sale. Once the shares have been borrowed or “located” by the broker-dealer, they will be sold in the market and the proceeds deposited in the trader’s margin account.
- Short selling involves a number of additional costs apart from trading commissions, including margin interest, stock borrowing costs, and dividends. In addition to significant expenses, other risks associated with shorting include the risk of a short squeeze or buy-in, regulatory risk, the fact that short selling is contrary to the long-term upward trend, and a skewed payoff ratio.
- The two biggest recent changes in US short selling regulations – Regulation SHO and Rule 201 – were implemented in the years after the “tech wreck” of 2000-02 and the global bear market of 2008-09. Regulation SHO was implemented in January 2005 and updated short sale regulations that had been essentially unchanged since 1938. It specifically sought to curb the practice of “naked” short selling by imposing “locate” and “close-out” requirements on broker-dealers for short sales. In February 2010, the SEC adopted an “alternative uptick rule” or Rule 201, which restricts short selling by triggering a circuit breaker when a stock has dropped at least 10% in one day.
- Two of the most useful indicators for analyzing potential short sales are short interest and the short interest ratio.
- Investors who wish to act on a bearish view with regard to a stock, sector, or the broad market, have a couple of alternatives to short selling: put options and inverse ETFs.
Remember, short selling carries less risk when the security being shorted is an index or ETF, since the risk of runaway gains in them due to a short squeeze is much lower than it is for an individual stock. Short selling risk can also be mitigated by buying calls to hedge the risk of a short position going awry. This is the mirror image of a long stock + long protective put strategy.
Because of its many risks, short selling should only be used by disciplined traders who are familiar with the risks of shorting and the regulations involved. Put buying is better suited for the average investor than short selling because of the limited risk. That said, short selling could be a potent strategy for speculation or hedging during bear markets.
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