Short Selling – How Does It Work? | How Do You Short a Stock?

Short selling allows investors to bet against a stock, profiting when it falls in price. Today we are going to talk about short selling, what it is, how it works, the risks involved and what you need to know about it. We will talk about how you can enhance the returns of your portfolio by lending out your shares to short sellers, and at the end of the video we will see what the returns of short selling hedge funds look like in the long run. We walk through the pros and cons of shorting stocks and how you short a stock in your online trading software.

Welcome back to patrick boyle on finance today we’re going to talk about short selling what is it how does it work what are the risks involved and what do you need to know about it to short sell stocks we’ll talk about how you can possibly enhance the returns of your portfolio by lending out your shares to short sellers and at the end of the video we’ll see

What the returns of short selling hedge funds look like in the long run for most traders and investors the way to make money in the stock market is simply to buy and hold financial securities with the hope that their value will increase over time along with any cash flows you might receive such as interest payments or dividends you mostly profit from the price

Or capital appreciation but what happens if you think the price of a financial security is likely to fall rather than rise with traditional investing you can’t really make money from that you can of course avoid owning the security and avoid losing money but with short selling traders can attempt to profit from the decline of a securities market price if you

Ever short stocks as part of your investing strategy let me know in the comment section and tell me generally how it works out for you so how does short selling actually work well short selling stocks flips the traditional investing approach on its head most investors aim to buy low and sell high short sellers do the reverse of this once they identify a short

Selling candidate their broker finds and borrows the securities from another investor who owns those shares on their behalf the trader then sells those borrowed shares that they don’t own waits for the share price to decline and buys the shares back at a lower price traders are charged interest on the stocks borrowed in a short sale once the short sale is complete

The trader returns the borrowed shares to the broker who collects fees and any interest and the trader gets to keep any profits from the transaction hopefully it makes sense to you that you have to borrow the shares first as of course when you sell something someone else has bought it from you and they will of course expect to see those shares settle in their

Account thus the borrowing is required different brokers will differ in terms of the availability of shares that they have to borrow and for this reason professional traders often have accounts with more than one broker so how do you go about this well in order to short stocks you have to first open a margin account with your broker which will usually involve

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Signing some additional risk disclosure statements and often it will also require a credit check as well and can even involve having to verify your income usually in order to short a stock you need to have at least fifty percent of the cost of the position you are selling short in your margin account before making the trade so if you wish to sell ten thousand

Dollars worth of shares short you must have at least five thousand dollars in your account there’s also a maintenance margin level where if you’re short of stock and its price rises causing losses in your account if your margin falls to less than 30 percent of the equity’s value you either have to top up or add cash into your margin account that day or your broker

Will close out your position locking in your losses when i first started out in finance and i learned about short selling it seemed like a great idea to me i figured that it had to be easier to work out which stocks were terrible rather than working out which stocks were great the problem with that logic of course is that when everyone can see that a business

Model is failing or that a company is being mismanaged there’s a huge incentive in place for a change of direction so a poorly performing company can be bought out by a better managed firm an activist investor can get involved and agitate for change or the management of the firm can possibly pivot into a more lucrative line of business even in a world without

The ability to short stocks if you could identify underperforming stocks you could easily outperform by just buying all of the good stocks and avoiding the bad ones so being able to short is not necessarily the additional edge that it may first appear to be when you hear about it so what are the other problems with shorting stocks well when you buy a stock the

Most you can lose is the money you invested in the stock you can lose a hundred percent if the stock falls all the way to zero on the other hand you do have unlimited upside when you’re long a stock and that’s just because the stock can double triple quadruple in value there there’s theoretically no limit to how much a stock can rise now when you short a stock

If it doubles in value you lose one hundred percent but of course it can more than double in value thus if you shorted ten thousand dollars worth of a stock you can lose significantly more than ten thousand dollars in fact you have unlimited downside while the most you can make is if the stock falls to zero in which case you’ll have doubled your money the risk

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Reward is not really in your favor as a short seller in fact it’s specifically asymmetric and in favor of long stockholders positions when you own a stock you receive the dividends in the long run dividends actually make up around half of an investor’s total returns from investing if you have borrowed a stock to short it and it pays a dividend you actually have

To pay this amount to your broker each time a dividend is paid on your short stock position there are other costs as well associated with shorting stock when you borrow stock someone will have lent it to you and of course no one’s going to do this for free so you have to pay an interest rate for this loan stocks that are considered gc or general collateral can

Be borrowed at a rate of around a half a percent per year hard to borrow stocks such as highly liquid stocks or those with very tiny public floats or a significant shorter interest already maybe due to a famous activist hedge fund loudly touting their short selling that can cost as much as 70 percent per year to borrow in such a situation you really really

Have to be right about the stock falling in order to make money a lot of the reason that index funds and etfs are actually able to charge such low fees is that they lend out their shares in their underlying portfolio companies to short sellers and get extra performance from these lending fees many retail brokers like interactive brokers and e-trade allowed

Their customers to participate in stock lending your broker can lend out your shares and split the fees with you a few years ago interactive brokers was offering owners of sears a 50 borrow rate so if you had 10 000 in sears stock and lent it out for a year you’d make five thousand dollars the chart on screen right now shows the most expensive stocks to borrow

From last year even when you have secured stock borrow you’re not always safe the person who’s lent it to you can call it back at any point resulting in your broker covering your short for you if they can’t locate more shares for you this is known as buy-in risk there are other potential drags on your return as a short seller such as the uptick rule the uptick

Rule was introduced after the 1929 stock market crash and it was designed to prevent short sellers from accelerating downward momentum of a falling stock it means that you can only get filled on a short sale when the stock price ticks up the rule was eliminated in 2007 and then replaced with a new rule in 2010 the new rule is triggered when a stock price falls

At least 10 percent in a day at that point short selling is permitted if the price is above the current best bid this aims to preserve investor confidence and promote market stability during periods of stress and volatility the rule applies for the remainder of the trading day and the following day so how do you do this in your brokerage account in most online

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Brokerage accounts assuming you’ve signed up for a margin account you can usually see on your screen if your broker has an inventory of shares available to borrow often it shows as etb on your trading app which stands for easy to borrow in such a situation you can just hit a button in your trading app to sell the share short a lot of online brokers label other

Stocks as htb or hard to borrow or ntb meaning that there are no shares available to borrow for hard to borrow names you often have to be pre-approved for your broker’s hard to borrow program in order to be able to borrow them so why might short sell well there’s a lot of trading strategies where short selling is central to how they work a good example of that is

Merger arbitrage and i made a video about a week ago explaining merger arbitrage and i’ll link to that in the description below short selling makes sense and is in fact fundamental within that sort of hedged or market neutral trading strategy where it is generally being used to reduce risk rather than to add risk generally short selling is considered an advanced

Strategy and not well suited to most investors goals most stocks tend to drift upwards over time about 53 of days are up days in the stock market and 65 of months over the last hundred years were up months when you short sell it’s a little bit like swimming upstream most companies are businesses employing people who come in every day and work to generate value

When you’re short selling you’re betting against their efforts being fruitful an investment in the stock market of a hundred dollars a hundred years ago would be worth around two million dollars today short sellers are likely to get the opposite of that return unless they’re really good at their short stock selections so if short selling is not well suited to

Retail traders how does it work out for professional investors in truth not a whole lot better the chart on screen right now is the return of the hfrx short bias index it shows the returns of short selling hedge funds over the last 16 years as you can see they had positive returns during the credit crunch but didn’t make as much money as you might have expected

Given the size of the market falls over that time frame and overall they lost 10 and a half percent almost 11 a year it might be better for your financial health thus to search for stocks most likely to rise than the ones most likely to fall if you found this useful please hit the like button and if you’d like to see more videos like this do subscribe see you later bye

Transcribed from video
Short Selling – How Does It Work? | How Do You Short a Stock? By Patrick Boyle

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