LEVEL: INTERMEDIATE
Short selling is defined as borrowing a stock, selling the stock short, and repurchasing the stock once the market falls to a lower level in an effort to profit from the decline of the stock. Investors can include short sales into portfolio strategies which include outright directional short sales, pair trading, and option strategies. Investors historically have used short selling to hedge risk exposure. Short selling can be categorized as either covered short selling or naked short selling. This article will focus on describing short selling along with the strategies that can be used which benefit from short selling.
How to Short Sell
A covered short sale of a stock can only occur if an investor has a margin account. This type of account will allow an investor to borrow funds against the stock and then sell the stock short. The stock is borrowed using the stock itself as collateral, sold and then repurchased preferably at lower levels.
Generally, less liquid stocks are harder to borrow than more liquid stocks. In a covered short sale trade the lender is collateralizing the transaction against the stock that will be returned to it by the short seller. The process is called covered because the short sale is covered by a borrowed stock.
The risk than an investors initiates when short selling a stock is without bounds given that a stock could rise to an infinite level. Given that a stock could rise without bounds, the volatility associated with a short position is significant. Short selling is used as a strategy that anticipates a price fall, but generates substantial upside risk.
Short selling can occur without an investor borrowing the underlying stock. This is referred to as Naked Short Selling. Although investors should borrow a stock prior to short selling the stock, this practice cannot always be achieved.
During a short sale transaction the stock needs to be acquired prior to the delivery period. If the short seller of a stock does not acquire the stock prior to this period, the result is known as a failure to deliver. This type of transaction will remain open until the stock is obtained by the seller, or closed by the seller’s broker.
In 2008, the SEC banned naked short selling as a method used by investors to drive down share prices and creating negative momentum for a stock. Failing to deliver a stock and naked short selling is not necessarily illegal. The SEC wants to avoid the process of investors avoiding stock borrowing and quickly short selling stocks to create negative momentum.
Why Does Naked Short Selling Happen?
Unfortunately a situation can occur where the inventory of a stock is in limited, and shares of the stock to borrow can be limited. The cost associated with borrowing an illiquid stock specifically the interest rate that a lender might charge could be prohibitive.
If a short sale transaction generates a “fail to deliver” the trade will remain open until rectified by the short seller. The trade can be close if the buyer is credited the stock by the Depository Trust Clearing Corp.
If naked short sales are transacted in a stock that is considered liquid it may not be noticed by regulators. If the shares of a short sale cannot be obtained, the trades will fail. Failure reports are published regularly by the SEC, which are monitored regularly, which might generate unwanted attention to the short seller. When an investor repurchases a shorted stock, the transaction is referred to as “covering short positions”. Shorting a stock creates liquidity within a market place.
Strategies
Short sales are actively used in many different types of trading strategies. The most common type of strategy associated with a short sale is a directional trade in which the short seller is looking for a particular stock price to decline.
Another type of trading strategy that is popular which uses short sales is pair trading. In this type of strategy an investor purchase one stock and simultaneously shorts sells another stock that is in a similar business. Pair trades generally involve stocks that move in tandem with one another and have highly correlated returns. For example, many investors pair trade highly correlated companies, such as Hewlett Packard and Dell which are in the same businesses to generate robust returns.
Hedging
Investors will use short sales to hedge a portfolio of stocks. Short sales of indexes such as the S&P 500 index are a popular way investors hedge their portfolios. For example, if an investors has a portfolio of large cap stocks and believes that market conditions are setting up for an adverse move in their portfolio, they could hedge their positions by shorting the Spider Select S&P 500 ETF (NYSE:SPY) which could mitigate some of their losses in the event of an adverse movement in the market. When determining the amount of risk to hedge, an investor could calculate the notional value of their portfolio and short sell an equivalent amount of a broader index.
There are also a number of options strategies in which an investor can use a short sale to hedge a portfolio of options. If an investor has a theoretical long position created by call options, they might consider short selling the delta (the theoretical underlying outright position) of their portfolio. A short sale of the delta of a portfolio would theoretically eliminate the outright directional risk of a call options. For example, if an investor has long call position in IBM, they could sell short Apple stock to hedge their option position.
Summary
Short selling is an important function for market operations. Allowing investor to short sell provides liquidity as investors are selling and creating a market place where there are buyers and sellers. Short sales plays an important role in the capital markets, however the risks associated with naked short selling can be extreme as there is no limit on the potential losses. The borrowing associated with covered sales plays a role as it limits short sales to companies in which investors are willing to lend using a stock as collateral which mitigates the momentum associated with naked short sales.