What is Short Selling a Stock?

What is short selling?

How do you short a stock?

Those are the 2 questions we want to answer.

This is going to be a very beginner friendly explanation.

What is Short Selling?

I decided to ask ChatGPT and Grok the AI tool from X to give us an easy example to start with. Here it is:

Short Selling: Selling High, Then Buying Low

Instead of buying low and selling high, with short selling you are selling high, and buying low.

How Short Selling Works in the Stock Market

• Borrowing Shares: You think a company’s stock price is going to go down. So, you borrow shares of that company’s stock from your brokerage firm. The brokerage firm has these shares either in its own inventory or from other customers’ accounts (who are not planning to sell them right away).
• Selling the Borrowed Shares: Once you borrow the shares, you sell them at the current market price.
• Hoping the Price Drops: You wait and hope that the stock price falls, just like you thought it would.
• Buying Back the Shares: If the stock price does drop, you buy the same number of shares back at the lower price.
• Returning the Shares and Profiting: After buying them back, you return the shares to the brokerage firm (or the original owner). The difference between the price you sold the shares and the lower price you bought them back at is your profit.

This Process is Seamless in Your Brokerage Account

When you short sell a stock through your brokerage account, the process of borrowing shares and then selling them is typically handled electronically and seamlessly behind the scenes. Here’s a brief overview of how it works:

• Initiating a Short Sale: In your brokerage account, you would enter an order to short sell a specific number of shares of the stock you believe will decrease in value. This is usually done through a simple interface where you specify the stock and the number of shares you want to short.
• Borrowing Shares: Once you place the short sell order, the brokerage automatically handles the process of borrowing shares. The brokerage sources these shares from its inventory or from other clients’ accounts that have opted in for share lending programs.
• Selling the Borrowed Shares: After the shares are borrowed, they are sold at the current market price. This transaction is executed just like a regular stock sale, and the proceeds from the sale are credited to your account.
• Transparency for the Trader: As a trader, you won’t see the intricate details of which specific shares were borrowed or whose account they came from. The brokerage handles these logistics.
• User Interface Simplicity: The brokerage platform’s user interface is designed to make the process straightforward. You don’t have to manage the logistics of borrowing shares; you simply execute a short sell order, and the brokerage takes care of the rest.

When you short sell a stock, the process of borrowing and selling shares is handled behind the scenes by your brokerage. As a trader, your main interaction is simply to place the short sell order through your brokerage account’s interface.

Why the Brokerage Firm Lends You Shares

• Fees and Interest: The brokerage firm can charge fees or interest for lending out the shares. It’s a way for them to make extra money.
• Stock Availability: They lend shares they already have, either in their own inventory or from other customers’ accounts who are not using them right now.

Risks to the Brokerage

• Market Risk: The brokerage firm’s risk is minimal in this scenario because it is not exposed to the stock’s price fluctuations.
• Counterparty Risk: The main risk to the brokerage is if you, the borrower, cannot buy back the shares to return them (for example, if the stock price rises significantly). In such cases, the brokerage might have measures like margin calls to manage this risk.

A quick note on margin: When you short sell a stock and the price goes up instead of down, you could start losing money. If your losses get too big and you don’t have enough money in your account to cover the position, the brokerage steps in with a safety measure called a margin call. This is like an alert telling you to add more money or securities to your account to cover the potential loss. If you can’t do this, the brokerage will step in and close your position by buying back the shares at the current price, even if it means you’ll take a loss. This is done to prevent the situation from getting worse and to protect both you and the brokerage.

Who Bears the Risk?

• Short Seller: You bear the risk of the stock price moving against your position (going up instead of down). If this happens, you could lose money.
• Original Share Owner: The person who owns the shares and allows them to be lent out does not lose money from the lending itself. However, they are exposed to market risk in their investment, like any stockholder.

Brokerage Firm’s Responsibility

• Providing Shares for Sale: When the original owner decides to sell their shares, the brokerage firm is responsible for making sure those shares are available to sell, even if they are currently lent out for short selling.
• Replacing Borrowed Shares: If the shares are out on loan, the brokerage will typically use other shares from its inventory or from another client’s holdings who is not currently selling. This is possible because shares of a particular stock are interchangeable – they are not unique to each investor.

When you borrow and sell shares in a short sale, the original owner still “owns” their shares in terms of market value and rights, even though those specific shares might have been sold in the market. The brokerage ensures that the owner’s rights are intact and that you, as the short seller, replace the equivalent number of shares when you close your position.

When an original stock owner decides to sell their shares, the brokerage firm ensures the seamless execution of the sale, even if those shares are currently lent out for short selling. The process is managed in a way that the sale by the owner and the borrowing by the short seller are both accommodated without conflict.

Did I Agree to Lend My Shares?

• Consent: When you open an account with a brokerage, you are usually required to agree to its terms and services. These terms often include a clause that allows the brokerage to lend out your securities.
• Margin Accounts: The lending of shares is more common with margin accounts, where investors are trading with borrowed money. In such accounts, investors often agree to allow their securities to be used for lending to short sellers.
• Optional for Some Accounts: In some cases, especially with cash accounts, the lending of shares may not be automatic, and you might have to opt-in or sign a separate securities lending agreement.

Benefits to Brokerage and Investors

• For Brokerages: Lending out securities allows brokerages to earn additional revenue through lending fees charged to borrowers (short sellers).
• For Investors: Some brokerages share a portion of the lending income with investors whose shares are being lent out. This can be an added incentive for investors to allow their shares to be used in this way.

Why People Short Stocks

• They Expect the Stock Price to Fall: People short stocks because they believe the price of the stock is going to go down. They want to profit from this expected price drop.
• Profit from Overvalued Stocks: Sometimes, investors think a stock’s price is higher than it should be based on the company’s actual value. They short sell these stocks, betting that the market will eventually lower the price to its true value.
• Hedging: Some investors short sell as a way to protect their other investments. If they think the market might go down, short selling can help balance their losses from other stocks.

In Summary

Short selling is like the reverse of the usual process of buying and then selling. Instead, you sell first at a high price and hope to buy back later at a lower price to make a profit. People do this when they think a stock’s price is going to fall, either because it’s overvalued or as a strategy to balance their investment risks.

Example: The Fall of Nikola

Trevor Milton, the founder of Nikola Corporation, was found guilty of fraud and sentenced to four years in prison. He made false statements about the company’s technology and future sales prospects, which pumped up the stock price. He claimed that Nikola had developed a working prototype of a hydrogen fuel cell-powered semi-truck called the Nikola One, but in reality, the truck was not fully functional and was not powered by its own propulsion system. Milton also claimed that Nikola had developed a breakthrough battery technology that would double the range of electric vehicles, but this technology did not exist. Additionally, he exaggerated the company’s production capabilities and sales projections, leading investors to believe that Nikola was further along in its development than it actually was.

The fraud scandal broke in September 2020, when a report from Hindenburg Research, a short-selling investment firm, exposed many of the company’s false claims and misleading statements. After the scandal broke, Nikola’s stock plummeted, leaving many investors with significant losses. The company has since tried to distance itself from Milton and move forward, but the damage to its reputation and finances has been substantial.

When this story broke, I remember thinking, “hey, maybe I should short the stock…” I never actually did, but let’s use the scenario of Trevor Milton and the fraud scandal as an example to illustrate how short selling could have worked. We’ll use hypothetical numbers based on the stock prices at the time:

Initial Situation (September 2020)

• Stock Price: Imagine the stock was trading at around $35 per share when news of the fraud scandal started to surface.
• Prediction: You predict that the stock price will fall significantly due to the scandal.

Steps for Short Selling

1. Borrowing Shares: In September 2020, you decide to short sell the stock. You borrow, let’s say, 100 shares from your brokerage at the current price of $35 per share.
2. Selling the Borrowed Shares: You then immediately sell these 100 borrowed shares in the market at $35 each, receiving $3,500 (100 shares x $35/share).

Waiting for the Price Drop

• Over the next few months, as the details of the fraud become more public, the stock price begins to plummet.

Closing the Short Position (At a Later Date)

• Let’s say, as of now (2024), the stock price has fallen to $0.70 per share.
• You decide to close your short position by buying back the 100 shares at this new price, which would cost you $70 (100 shares x $0.70/share).

Profit from the Short Sale

• Selling Price: You initially sold the shares for $3,500.
• Buying Price: You later bought them back for $70.
• Profit: Your profit is the difference, which is $3,500 – $70 = $3,430, minus any fees or interest charged by your brokerage.

Summary

• By predicting that the stock would fall due to the scandal and short selling the shares, you managed to make a significant profit as the stock price dropped drastically.