9 Frequently Asked Questions About Short Selling

by: Charles Schwab

Summary

Directional short selling is the sale of a borrowed stock if a trader anticipates that the price of a security will drop.

The shares used for short selling are supplied from various sources, such as borrowed from long positions held in other clients' margin accounts, or from an external firm.

A buy-stop or trailing buy-stop order can help to manage loss on a short sale, in case the stock price goes up.

Though short-selling is an advanced trading strategy and involves potentially unlimited risks, traders who know what to look for can still use it to their advantage. To walk you through the basics of what short-selling is and how to recognize opportunities to implement it, we'll take a look at nine frequently asked questions and some explanatory examples.

1. What is directional short selling?

Directional short selling is the sale of a borrowed stock. Traders might consider this bearish strategy if they anticipate that the price of a security will drop.

To start a directional short sale, the trader sells the borrowed security (see Where do the shares come from?). The negative share balance is then maintained in the trader's margin account as a "short position." Then, to close the short position, the trader must buy back the security. If the price drops, the trader can buy back the stock at the lower price and make a profit on the difference. However, if the price of the stock rises, the trader buys back the security at a higher price for a loss.

2. Why would someone sell a stock short?

Many people buy stocks when they are bullish, but short selling also allows them to take a position when they believe a stock price may decrease in the future. If someone is bearish and believes a stock price will only decrease, they may want to sell shares now, and buy them back at a discount later, thereby creating a profit. This is called a directional short. People also sell short to facilitate hedging and arbitrage, but we will focus on directional shorts.

Short Selling Example image
Short selling example
Source: Schwab Center for Financial Research.

Let's take a look at a few examples of how profit or loss is calculated on a short sale trade. Please note that, for simplicity, trade commissions and fees have been excluded from the calculations below.

Example:

  • Short 100 shares XYZ @ $20, total proceeds = $2,000
  • Stock price drops to $15, client buys back the 100 shares XYZ @ $15, total cost $1,500
  • Total profit = $2,000 - $1,500 = $500

The maximum gain on a short position is the amount of proceeds received on the sale, and would occur if the stock price went to zero.

Example: If the client shorts 100 XYZ @ $20, and the stock price goes to $1, the client buys, or closes, at $1 and keeps the proceeds from the short sale ($1,900).

However, the maximum loss on a short is unlimited: The short seller's losses accumulate as the price goes up, and the stock price could theoretically increase infinitely.

Example: If the client shorts 100 XYZ @ $20, then the stock price increased to (and remained at) $30, the client could be stuck buying the stock at $30, realizing a $1,000 total loss on the trade.

3. Where do the shares come from?

The shares used for short selling are supplied from various sources. Many times they are supplied internally, borrowed from long positions held in other Schwab clients' margin accounts. In the margin agreement, as collateral for existing margin debit balances, clients agree to lend positions held in their margin accounts to Schwab for the purpose of lending to other market participants for short selling. Typically, Schwab can borrow stock worth up to 140% of the debit balance amount from a margin account. Schwab cannot borrow securities that are paid for in full and settled.

If shares aren't available internally, Schwab's Securities Lending Department can seek shares outside the firm. Such loans may often incur an interest fee, which is charged to the borrowing client each day the shares are borrowed. For more information on securing shares from outside of Schwab, clients can contact the Securities Lending Department at 800-355-2448.

4. How does short selling work?

Schwab arranges for share borrowing internally or externally via an outside custodian bank or broker-dealer. If shares are borrowed internally, the client from whom the shares are borrowed will not experience any restrictions to their position or account. However, short selling can negatively impact the price of the stock. Let's take a look at how a short sale of shares borrowed internally might work:

Short Selling in practice image
Short selling in practice
Source: Schwab Center for Financial Research.

  1. Mr. Armstrong buys 300 shares of XYZ stock in his margin account. He is bullish on the stock, believes the stock will go up over time, and enjoys the dividend payment he receives on the stock.
  2. Ms. Bourne, however, is bearish on XYZ, and believes the price will soon decrease. To implement her bearish strategy, Ms. Bourne enters an order to sell short 100 shares XYZ.
  3. Schwab borrows the 100 shares from Mr. Armstrong to lend to Ms. Bourne to sell in the market.
  4. When the short sale is executed, Mr. Armstrong's account and positions remain unchanged, but Ms. Bourne's account will show a short position (-100 shares XYZ).

Dividends: What if a dividend is paid on XYZ while the shares are being borrowed?

  • Schwab will typically allocate a substitute dividend payment to the lender, Mr. Armstrong, in lieu of the dividend, and will debit the substitute dividend payment amount from the borrower, Ms. Bourne.
  • The payment in lieu of the dividend may not be entitled to the same tax treatment as may have been applied to the receipt of the actual dividend. However, Schwab typically makes efforts to compensate lenders for any differential tax treatment. Please refer to your Schwab Account Agreement for more information on payments in lieu of dividends.

Position closure: What if Mr. Armstrong wants to sell all 300 shares of XYZ?

  • Mr. Armstrong simply places the sell order for 300 XYZ as usual. He is free to do this as he is the rightful owner of the shares.
  • If there are additional shares available for shorting, Ms. Bourne may continue holding her short position using those additional shares.
  • If the sale causes shares to no longer be available, Ms. Bourne's short position will be closed out through a purchase at the current market price by Schwab at Ms. Bourne's expense and potentially without notice. This enables proper delivery of the shares to Mr. Armstrong.

5. How do I know if there are shares available to borrow?

StreetSmart Edge® has a hard-to-borrow (HTB) indicator to let clients know that shares of a security are hard to borrow for shorting. However, the absence of the indicator for a particular security does not guarantee that it will be available to sell short. If you have further questions about the availability of a particular security to sell short, please contact a Schwab representative.

In StreetSmart Edge®, the indicator appears to the right of the Trade - All in One tools.

Click to enlarge
HTB indicator in StreetSmart Edge
Source: Trade - All in One, StreetSmart Edge.

In StreetSmart.com, the indicator is located at the top of the Stock Trade ticket in the Trading > Stocks tab.

Click to enlarge
HTB indicator in StreetSmart.com
Source: StreetSmart.com.

6. What is intentional naked short selling?

Intentional or abusive naked short selling is the illegal practice of selling a security without having borrowed the shares. Abusive naked shorting is considered manipulative, as it involves intentionally selling shares that don't exist, negatively affecting the stock price without regard to supply and demand.

Before executing a short sale order, Schwab will first determine if there are sufficient shares available to lend for settlement. If sufficient shares are not available, Schwab will cancel or reject the order. Likewise, if a client has a short position and borrowed shares are no longer available to short, the client's short position will be closed out (bought back) at the current market price by Schwab, at the client's expense and possibly without notice. It's important to keep in mind that the supply and demand of shares available to borrow changes over time.

7. What are the margin requirements?

Shorting can only be done in a margin account, and is subject to the initial minimum $5,000 equity requirement for using margin.

Schwab's initial and margin maintenance requirements on short sales:

Security price Schwab initial requirements (prior to settlement) Schwab maintenance requirements
(subsequent to settlement)
> $16.67 per share 50% of proceeds 30% of market value
$5 - $16.67 per share 50% of proceeds $5 per share
$2.50 - $5 per share 50% of proceeds 100% of market value
< $2.50 per share 50% of proceeds $2.50 per share
Click to enlarge

Source: Charles Schwab & Co., Inc.

For example, if you sold short 100 shares of XYZ stock at $20, you would need to have half the proceeds of that sale, equivalent to $1,000, in your margin account at that time. After the sale settled, you would need to keep cash or securities equivalent to at least 30 percent of the stock's market value in your margin account. If the price stayed at $20, that would mean keeping at least $600 in the account.

It's important to note that this table is just a guideline. If a stock has a higher margin maintenance requirement, the maintenance requirement on the short will also be higher (the above figures assume a margin equity requirement of 30%). It's also important to note that these requirements can change at any time and without prior notice from Schwab.

8. When do I have to buy the shares back?

There are no regulations that limit the amount of time a short position can be open. However, some conditions may cause a short position to be closed:

  • Shares are no longer available to borrow. When a client borrows shares to short sell, the lender retains the right to recall the securities at any time and without notice. If the shares are recalled by the lender, Schwab will try to re-borrow the securities on the client's behalf. However, if shares cannot be obtained, Schwab would be forced to cover the client's short position at the market price at the client's expense and potentially without notice.
  • Margin call. Just as long positions in accounts with margin calls are subject to liquidation at the discretion of the Margin Department, a short position is also subject to possible closure when a margin call exists.

9. How can I help manage risk on a short sale?

The potentially unlimited loss associated with a short sale makes it important to proactively manage the risk.

Just as a sell-stop or trailing sell-stop orders can help control losses on a long purchase, a buy-stop or trailing buy-stop order can help to manage loss on a short sale, in case the stock price goes up.

For a short sale, buy-stop orders trigger a market order to buy back when the ask price is equal to, or greater than, the stop price entered.

A trailing buy-stop involves an entered dollar or percentage amount above the current market. If the ask price only moves upward (against you), the trailing stop will track the ask price until it reaches or surpasses your entered trailing amount. However, unlike the standard buy-stop order, when the price moves downward (in your favor), a trailing buy-stop will readjust the trigger price from the new low ask price reached.

Let's take a look at an example of how risk management can help to control loss on a short sale. Please note that, for simplicity, commissions and fees have not been considered in the example below, but can affect individual profit/loss results.

Example:

Mr. Armstrong shorts 100 shares of XYZ stock at $30. Initially, the stock price moves down to an ask/offer of $27, but then builds back up and ends the day with an ask/offer of $33.

  • If Mr. Armstrong had no risk protection on his trade and closed the position at the end of the day, he would end the day with a loss of $3 per share ($300).
  • If Mr. Armstrong had set a buy-stop on this order for $32 ($2 above sale price), the stop would have triggered when the ask/offer increased to $32, and the client would incur a loss of approximately $2 per share ($200).
  • If Mr. Armstrong had set a trailing buy-stop on this order for $2, the initial trigger would take place at the ask/offer of $32. However, as the price moved downward, the trailing stop would have readjusted with each new low, settling to $2 above $27, or $29.
  • As the price changed directions, the trailing buy-stop would have tracked the upward movement until the ask hit $29, at which point the market order to buy would have triggered, resulting in approximately a $1 per share ($100) gain for the client.

Keep in mind that there is no guarantee that a stop order will execute at or near the stop price.

Important Disclosures

For the sake of simplicity, the examples in this presentation do not take into consideration commissions and other transaction fees, tax considerations, or margin requirements, which are factors that may significantly affect the economic consequences of strategies displayed and there can be no assurance that any strategy will be successful. Please contact a tax advisor for the tax implications involved in these strategies.

When considering a margin loan, you should determine how the use of margin fits your own investment philosophy. Because of the risks involved, it is important that you fully understand the rules and requirements involved in trading securities on margin:

You can lose more funds than you deposit in the margin account;

Schwab can force the sale of securities or other assets in your account(s);

Schwab can sell your securities or other assets without contacting you;

You are not entitled to choose which securities or other assets in your account(s) are liquidated;

The firm can increase its "house" maintenance margin requirements at any time and is not required to provide you advance written notice;

You are not entitled to an extension of time on a margin call.

Please read the Margin Handbook for more information.

Actual stock symbols used are for illustrative purposes only and should not be construed as a recommendation to buy, or solicitation to sell any particular security.

Schwab Trading Services (formerly known as Active Trader or Active Trading services) includes access to StreetSmart® trading platforms, the Schwab Trading Community, and priority access to Schwab trading specialists. Call 888-245-6864 to request access (a Schwab brokerage account is required). Schwab reserves the right to restrict or modify access at any time. Access to electronic services may be limited or unavailable during periods of peak demand, market volatility, systems upgrades or maintenance, or for other reasons.

The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.