Why Do Investors Short Stocks?

Why do investors short stocks? “Shorting’ stocks is a strategy to profit from a decline of a stock’s price. Investors use this strategy to “hedge” an investment portfolio, profit from a decline of a stock’s price, or to lock-in the value of a stock without selling the stock.

Example of shorting a stock:

Stock Ticker: SHRT
Current Price: $25
Hypothetical (A) Future Price: $30
Hypothetical (B) Future Price: $20

Investor shorts stock “SHRT” at $25:

Investor borrows 1,000 shares of SHRT from a financial firm having custody of shares in street name. Investor sells the borrowed 1,000 shares SHRT and receives $25,000 cash into investor account. Investor “covers” short position by buying the 1,000 shares of SHRT and returns the borrowed shares to the financial firm which lent the shares. The “lending” firm charges interest on the shares being borrowed also called “margin debt”.

Two Scenarios:

  1. SHRT price declines to $20/shareInvestor buys 1,000 shares at $20 in the open market at a cost of $20,000. Investor delivers the previously borrowed 1,000 shares back to the lender.  Investor profits $5,000.
  2. SHRT price increase to $30/share: Investor buys 1,000 shares at $30 in the open market at a cost of $30,000. Investor delivers the previously borrowed 1,000 shares back to the lender.  Investor loses $5,000.

A “Short squeeze”

 A short squeeze occurs when an investor (usually an institution with a large short position) scrambles to buy shares as a stock’s price is rising.  If the stock is illiquid the price may rise rapidly as sellers become reluctant to sell. The short seller is “squeezed” and must pay higher prices for the stock as the investor attempts to “cover” their short position.

Shorting is used to reduce a portfolios overall market exposure, thereby reducing the portfolio risk profile.

One very useful use of this hedging technique is to defer a capital gain. If an investor owns “ABC” at $50 per share with a $10 cost basis, the investor will incur a $40/share capital gain if sold.  If the investor would like to “lock-in” the $50 value but not sell the stock until a future date, the investor could short ABC. If ABC increases to $55 the investor would gain $5 from ABC long position, and lose $5 from the short position.  Conversely, if ABC declines by $5 per share, the ABC holding would decline by $5 and the investor would profit $5 from the short position. The investor would incur the borrowing cost relating to the short position.

While shorting is an excellent hedging technique, the risk is unlimited. Shorting should only be done by investors well informed about the risks involved.

Note: Past performance is not an indicator of future results. Investors could lose money investing in the stock and bond markets, among other capital markets.

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AS ALWAYS
We recommend only to invest in the stock market with a long-term view (3+ years) and have cash available for emergencies and spending needs for the short term (1-3 years).

PLAN FOR THE LONG TERM
PREPARE FOR SHORT TERM STOCK MARKET DECLINES