A short, or a short position, is created when a trader sells a security first with the intention of repurchasing it or covering it later at a lower price. There are two types of short positions: naked and covered. A naked short is when a trader sells a security without having possession of it. However, that practice is illegal in the U.S. for equities. A covered short is when a trader borrows the shares from a stock loan department; in return, the trader pays a borrow-rate during the time the short position is in place.
In short selling, a position is opened by borrowing shares of a stock or other asset that the investor believes will decrease in value by a set future date—the expiration date. The investor then sells these borrowed shares to buyers willing to pay the market price. Before the borrowed shares must be returned, the trader is betting that the price will continue to decline and they can purchase them at a lower cost.
The risk of loss on a short sale is theoretically unlimited since the price of any asset can climb to infinity. Also, short selling stocks require a margin account and usually incurs interest charges based on the value of the stock that is held short.
To open a short position, a trader must have a margin account and will usually have to pay interest on the value of the borrowed shares while the position is open. Also, the Financial Industry Regulatory Authority, Inc. (FINRA) the New York Stock Exchange (NYSE), and the Federal Reserve have set minimum values for the amount that the margin account must maintain—known as the maintenance margin.
To close a short position, a trader buys the shares back on the market—hopefully at a price less than what they borrowed the asset—and returns them to the lender or broker. Traders must account for any interest charged by the broker or commissions charged on trades.
A short-squeeze is when a heavily shorted stock suddenly begins to increase in price as traders that are short begin to cover the stock. One famous short-squeeze occurred in October 2008 when the shares of Volkswagen surged higher as short-sellers scrambled to cover their shares. During the short-squeeze, the stock rose from roughly €200 to €1000 in a little over a month.
Real example:
A trader thinks that Amazon’s stock is poised to fall after it reports quarterly results. To take advantage of this possibility, the trader borrows 1,000 shares of the stock from his stock loan department with the intent to short the stock. The trader than goes out and sells short the 1,000 shares for $1,500. In the following weeks, the company reports weaker than expected revenue and guides for a weaker than expected forward quarter. As a result, the stock plunges to $1,300, the trader then buys to cover the short position. The trade results in a gain of $200 per share or $200,000.
Imagine a trader who believes that XYZ stock—currently trading at $50—will decline in price in the next three months. They borrow 100 shares and sell them to another investor. The trader is now “short” 100 shares since they sold something that they did not own but had borrowed. The short sale was only made possible by borrowing the shares, which may not always be available if the stock is already heavily shorted by other traders.A week later, the company whose shares were shorted reports dismal financial results for the quarter, and the stock falls to $40. The trader decides to close the short position and buys 100 shares for $40 on the open market to replace the borrowed shares. The trader’s profit on the short sale, excluding commissions and interest on the margin account, is $1,000: ($50 – $40 = $10 x 100 shares = $1000).
Using the scenario above, let’s now suppose the trader did not close out the short position at $40 but decided to leave it open to capitalize on a further price decline. However, a competitor swoops in to acquire the company with a takeover offer of $65 per share and the stock soars. If the trader decides to close the short position at $65, the loss on the short sale would be $1,500: ($50 – $65 = negative $15 x 100 shares = $1500 loss). Here, the trader had to buy back the shares at a significantly higher price to cover their position.
Two metrics used to track short selling activity on a stock are:Short interest ratio (SIR)—also known as the short float—measures the ratio of shares that are currently shorted compared to the number of shares available or “floating” in the market. A very high SIR is associated with stocks that are falling or stocks that appear to be overvalued.The short interest to volume ratio—also known as the days to cover ratio—the total shares held short divided by the average daily trading volume of the stock. A high value for the days to cover ratio is also a bearish indication for a stock.
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