Shorting a stock can be a good trading strategy if an investor expects the value of a stock to go down. It is also a risky trade as theoretically the loss on a short trade can be infinite as a stock price can go as high as there are numbers. Any stock can be shorted.
When a private company goes public and sells its stock on an exchange for the first time, the process is known as an initial public offering (IPO). Stocks hitting the exchange after an IPO can be shorted upon initial trading, but it is not an easy thing to do at the start of the offering. First, you have to understand the process of IPOs and short selling.
- An initial public offering (IPO) occurs when a private company offers its shares to the public in a new stock issuance.
- Short selling occurs when an investor borrows a stock and repays it in the future, with the hope that the stock price will fall to make a profit.
- Lending institutions need an inventory of the stock before lending it to an investor.
- An IPO often offers a small number of shares, limiting what can be borrowed for shorting.
- The SEC prohibits IPO underwriters from lending out shares for a short sale for 30 days.
Initial Public Offering (IPO)
An IPO happens when a company goes from being private to being publicly traded on an exchange. The company and an underwriting firm will work together to price the offering for sale in the market and to promote the IPO to the public to make sure there's interest in the company. Generally, shares in the company are sold at a discount by the company to the underwriter. The underwriter then sells them on the market during the IPO.
When an investor short sells, he or she essentially borrows a stock and repays it in the future. If you do this, you're hoping the price of the stock will fall because you want to sell high and buy low. For example, if you short sell a stock at $25 and the price of the stock falls to $20, you will make $5 per share if you purchase the stock at $20 and close out the short position.
Challenges of Short Sales With IPOs
To be able to short a stock, you usually need to borrow it from an institution such as your brokerage firm. For them to lend it to you, they need an inventory of this stock. Here's where the difficulty can arise with IPOs and short selling.
An IPO usually has a small number of shares upon initial trading, which limits the number of shares that can be borrowed for shorting purposes. On the day of the IPO, two main parties hold inventory of the stock: the underwriters and institutional and retail investors.
As determined by the Securities and Exchange Commission (SEC), which is in charge of IPO regulation in the United States, the underwriters of the IPO are not allowed to lend out shares for a short sale for 30 days. On the other hand, institutional and retail investors can lend out their shares to investors who want to short them.
However, only a limited amount of shares would probably be available on the market as the company would've just started trading publicly and the shares may not have been completely transferred. Furthermore, there might be a lack of willingness among investors to lend their shares out to be short sold.
The Bottom Line
While there are regulatory and practical obstacles to short selling stock from an IPO, mainly via the limitations set on underwriters, short selling a company on the day of its IPO is still possible if institutional or retail investors who have purchased the stock lend it out for short selling. However, the amount of stocks available for short selling and the willingness of investors to do this immediately is small.