Personal Investor: Stock rally creates opportunity for short sellers
It’s been a banner 2019 for stock markets – so far, at least. With two weeks to go before the end of the first quarter, both the benchmark TSX Composite Index and S&P 500 are up by nearly 13 per cent.
Much of the rise comes as a rebound for stocks battered in late 2018, but with prices now in the high teens in relation to earnings there’s little doubt some have exceeded their fair value.
That’s when short selling could play a part in a seasoned investor’s portfolio. In the simplest terms, short selling is a way to make a profit when a stock goes down. Short sellers never own the stock – they merely borrow them, pay a premium, and promise to return them when they’re ready. Since short selling is a bet that the stock price will go down, the short seller hopes to return the stocks at a lower price and pocket the difference.
Here’s an example: suppose a short seller borrows 100 shares trading at $20 each and sells them on the open market for $2,000. Now suppose the share price falls to $15. The short seller is only required to return 100 shares at a cost of $1,500 – pocketing the remaining $500.
When you short a stock, your broker will lend it to you. The stock will come from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. Eventually you must "close" the short by buying back the same number of shares (called covering) and returning them to your broker.
Most of the time, you can hold a short for as long as you want (although interest is charged on margin accounts) so keeping a short sale open for a long time will cost more. However, you can be forced to cover it if the lender wants the stock you borrowed back. Brokerages can't sell what they don't have, so yours will either have to come up with new shares to borrow, or you'll have to cover. This is known as being “called away.”
The biggest risk for a short seller is the stock price going up. Unlike long positions, where the lowest a stock can go is zero, there’s no limit to how high a stock price can go – and no limit to how much a short seller can lose.