Most investors make money by buying a stock or other security at a low price, then selling it later for a higher price. Owning a security is having a long position in that security. Selling short is a way to profit when securities decline in price, by borrowing the securities, selling it, then hoping to be able to buy it back later at a lower price to replace the securities borrowed. However, if the securities pay a dividend or interest before the short is covered, then the short seller must pay those amounts to the lender of the securities.
To borrow securities to sell short, the broker may lend out securities from the brokerage's own inventory, securities from another brokerage, or securities held in the margin accounts of other investors. If the broker is unable to borrow the securities, as sometimes happens with illiquid securities, then the security cannot be sold short.
A broker can lend securities from the margin accounts of other investors, because the standard margin agreement allows it. When an investor opens a margin account at a brokerage, any securities bought for the account are held in the street name, the name of the brokerage for the beneficial interest of the investor, and as collateral for any borrowing. The standard margin agreement allows the broker to lend the securities held in its margin accounts to short sellers. A margin account is also required to sell short, since the liability of the account can increase more than the equity. When stock prices rise, the short seller incurs a greater liability for potential losses that may exceed the equity of the account, which is why the short seller needs to be creditworthy.
Example 1 — Profits and Losses from Selling Short.
An investor borrows 100 shares of XYZ stock currently trading at $35 per share and paying a 4% dividend, and sells it. Assume that the stock paid a dividend of $1.40 per share before the short seller covered his short. This puts $3,500 in the short seller's margin account, of which $140 will eventually be deducted to pay for the dividend. If the price subsequently declines to $30, the investor can buy it back for $3,000 to return the borrowed shares, thus covering the short position, and netting $500 - $140 = $360 from the trade. If, however, the price of the stock rises to $40, then the short seller must repurchase the stock for $4,000, resulting in a net loss of $500 + $140 = $640. Brokerage commissions and margin interest must also be subtracted from any profit or added to any loss. Note that for the same price movement of the stock, the loss from an unfavorable move always exceeds the profit gained from a favorable move.
Before 1998, many investors sold short stocks that they owned — selling short against the box — as a means to protect capital gains, or to convert a short-term gain into a long-term gain, which has a lower tax rate. However, this method has been rendered ineffective by the Taxpayer Relief Act of 1997. Any short sale against the box after June 8, 1997, is considered a constructive sale by the IRS, subject to a capital gains tax in the year of the sale.
A large investor may also sell short against the box to prevent the disclosure of his identity.
Calculating the Rate of Return for a Short Sale
Although a short seller receives money from a short sale, the short seller must post an additional margin requirement at least equal to the initial margin requirement, no less than 50% of the value of the shorted stock. So if $10,000 of stock is shorted, then the short seller must have at least $5,000 of equity to cover the liability for the short sale. The rate of return for a short sale is calculated by the following formula:
|(Stock Sale Price |
− Dividends Paid
− Margin Interest Paid
− Stock Repurchase Price)
|Short Rate of Return||=|
|Initial Margin Requirement|
So the rate of return in Example 1 for the profitable investment is ($3,500 - $140 - $3,000) / $1,750 = $360 / $1,750 = 20.57%, while the return of return for the investment loss = $640 / $1,750 = 36.57%. The $1,750 is based on an initial margin requirement of 50%.
Margin for Short Sales
Short sales can only be made from a margin account. A margin account can have no less than $2,000 of equity, the federal minimum requirement. Typically, a margin account allows the account holder to borrow up to 50% of the equity in the account for the purchase of new securities. There is also a maintenance requirement of 30% of the equity, though brokers can set it higher. (By contrast, the minimum maintenance requirement for long positions is 25%, though most brokers set it to at least 30%.) If the value of the equity drops below the minimum amount, then the broker issues a margin call. The investor must send more cash or other equity, or the broker will sell enough of the securities, to increase the total equity back to the minimum. However, while the equity is less than 50%, the account will be restricted, meaning that the account owner cannot buy more securities or sell securities short unless at least 50% of the value of the securities is deposited.
For more information about using margin for short sales, including calculating excess equity, loan value, and buying power, and the use of the SMA for margin accounts, please see Margin for Long and Short Positions, with Formulas and Examples.
Restrictions on Selling Short — the Short Sale Rule
Selling securities tends to decrease their price by increasing supply and reducing demand, so short sellers can actually drive down the price of the borrowed stock through their short sales. In the past, short sellers formed pools for this purpose.
To prevent this, the Securities and Exchange Commission enacted the short-sale rule in 1938, alternately known as the plus tick or uptick rule, which requires that a stock can only be sold short if the last transaction of the stock was a uptick, or an increase in price, or if there was no price change in the last transaction, but the previous change in price was an uptick, which is known as the zero-plus tick rule or the zero-uptick rule. However, the SEC terminated this rule in 2007.
In February 2010, the Commission adopted a new short sale price test restriction, the alternative uptick rule, officially known as Rule 201, to restrict short selling from further driving down stock prices, if the current stock price has dropped more than 10% from the closing price on the previous trading day. Rule 201 applies to any equity securities traded on a national securities exchange, including both listed and over-the-counter securities. If Rule 201 is triggered for a particular security, then short selling that security is prohibited for the rest of the day and the next day, unless the short sale price exceeds the current national best bid. If Rule 201 is triggered again, then the short-selling prohibition for the affected security applies for the remainder of the trading day and the next day. There is no limit to how many times this rule can be triggered, even if it is triggered on the 2nd day of a previous trigger. So if a stock drops at least 10% from its previous close, then Rule 201 applies for the remainder of the market day and the next day, but if the stock drops another 10% on the 2nd day, then the Rule 201 time period restarts, applying for the remainder of that day and the next day. Trading centers are required to prevent the execution or display of a prohibited short sale.
Short sales restrictions do not generally apply to derivative securities— securities whose prices depend on another security or basket of securities, such as exchange-traded funds, since the price of derivative securities depends on the prices of the underlying assets. Although derivative security prices depend on the instantaneous market supply and demand, just like any other security, derivative security prices will not drop much below the prices of the underlying assets; otherwise, investors would see it as a bargain and buy it, increasing the demand, and, thus, its price. In certain cases, arbitrageurs can take advantage of any significant differential in prices, which, in effect, closes the price gap between the securities.
A company insider also may not sell short the company's stock, which makes sense, since allowing this would allow company insiders to steal money from investors of the company, by selling the stock short, then issuing bad news to drive down the price of the stock.
Key Points to Remember about Selling Short
- Shares may be borrowed from your broker, another broker-dealer, or a custodian bank.
- The broker may forbid shorting stocks priced below a certain amount, such as $5, or odd lots (less than 100 shares).
- Short accounts are marked to market at the end of each trading day.
- Margin interest is charged on the debit balance, = equity − cash borrowed − market value of the shorted securities. Increases in the market price of a shorted security will increase proportionately the debit balance and the margin interest.
- If a stock is hard to borrow (HTB), meaning few shares are available for short selling, then the short seller must pay a daily stock borrow fee, based on the stock price and its availability; easy-to-borrow (ETB) shares do not have this fee. If shares are HTB, it will be noted after the order is entered but before it is verified; the broker’s software may also provide a way of checking before placing the order. Note, however, that the absence of a HTB indicator does not guarantee the stock will be easy to borrow.
- Because payments in lieu of the dividend do not have the favorable tax treatment as qualified dividends, the broker may require that the short seller compensate for this differential tax treatment. For instance, according to the Charles Schwab Margin Disclosure Statement, to compensate investors who would have received a qualified dividend, Schwab may pay a substitute income credit in addition to substitute payments in lieu of the dividend for those dividends that would have otherwise been taxed as a qualified dividend, but not for dividends that would be taxed as ordinary income. Presumably, this substitute income credit, in addition to the substitute payments in lieu of the dividend, would be charged to the short seller’s account.
- Margin requirements may differ depending on the stock. Low-priced securities or securities with higher volatility may require a higher maintenance margin percentage. The maintenance margin requirement most often differs for cheaper stocks. Many brokers require at least 100% of the market value of the shorted shares for cheap stocks, or a set amount for shares priced between certain amounts or a flat minimum for extremely cheap stocks. For instance, as of February 2021, Charles Schwab required a maintenance requirement of at least:
- 30% of market value for shares priced above $16.67 per share,
- $5 per share for stocks priced between $5 and $16.67 per share,
- 100% of market value for shares priced between $2.50 and $4.99 per share, and
- a flat $2.50 per share for any shares priced less than $2.50.
- If the original owner of the shares decides to sell and the broker cannot find more shares to borrow, then the shorted shares will be sold at the current market price, possibly without notifying the short seller beforehand. The broker may close out a short trade using a normal settlement basis, but if the short must be closed out quickly, then the broker may use next-day settlement or cash settlement, more expensive options. Failure to deliver the borrowed security back to its lender quickly enough may increase the cost for the short seller, such as if there was a tender offer for the security.
- Short-sellers often manage their risk by placing buy-stop orders and trailing buy-stop orders. A buy-stop order triggers a market order if the price of the shorted stock increases to the stop limit; a trailing buy-stop order specifies a percentage or dollar amount above the shorted security price where the stop limit declines any time the stock declines. However, the trailing stop limit does not increase when the stock price increases. Remember that market orders do not guarantee price.
You sell short XYZ stock for $50 per share, then the shares decline to $45, then rise to $55 within a week. Assume that the market orders execute at the stop price, which is never assured. A buy-stop order set at $53 will trigger a market order when the stock price reaches $53, causing a $3-per-share loss. A trailing buy-stop set at $3 will trigger at $48 per share, yielding a $2-per-share gain.
Naked Short Selling
Naked short selling is selling stock short without first borrowing it or arranging to borrow it. This often results from a failure to deliver (aka fail) the certificates to the buyer of the stock at settlement, resulting from an institutional failure to effect the transfer. But naked short selling is illegal as a means to drive down stock prices in order to buy at a better price. However, market makers are permitted to do some naked short selling to increase the liquidity of the market when it is difficult to borrow the stock quickly enough to satisfy market demand. Regulation SHO requires that the broker-dealer must locate the securities to be borrowed before selling them short, which means:
- the securities have already been borrowed or there is a bona fide agreement to do so;
- the broker-dealer reasonably believes the securities can be borrowed by the settlement date;
- it is assumed that the broker-dealer has reasonable grounds if the security is on the firm's Easy to Borrow list that was updated within the last 24 hours.
- The methods used to locate the securities was documented.
More Than 100% of Outstanding Shares Can Be Sold Short
Even without naked short selling, more than 100% of the float or even of the outstanding shares of a stock may be sold short. Investor A buys 100 shares of XYZ stock, then lends them out to a short seller. The short seller sells the 100 shares to Investor B, so Investor B owns 100 shares and Investor A still owns 100 shares, yielding a total ownership of 200 shares. This can easily be continued by other short-sellers and investors. The number of outstanding shares never exceeds 100%, but beneficial owners of the stock can easily own more than 100% of the outstanding stock, because short selling eliminates the requirement to have a one-to-one correspondence between current ownership and the number of shares outstanding. However, eventually short-sellers will have to buy back the stock. When all of the short interest is covered, then the beneficial ownership of the stock will return to 100% of the outstanding stock.
Risks of Selling Short
Selling short is risky. The most obvious risk is that the stock price can rise substantially. Stock prices can rise much higher than they can fall, and, therefore, the potential for losses exceeds the potential for profits.
Another risk is that the short seller may be forced to repurchase the stock, because the shares sold short were borrowed, and the lender may request those shares back at any time. Usually the broker can obtain other shares from other investors, but if the shares are scarce, such as occurs with securities with little float, then the broker may have no choice but to repurchase the shares at the current market price. Sometimes, investors long in a stock with a large short interest will buy more of the stock, or ask their broker to deliver the actual stock certificates to them, in the hope of forcing the short sellers to cover their position by buying the stock back — called a short squeeze. Short squeezes may become particularly painful to the short-sellers if more than 100% of the floating stock has been shorted, such as with GameStop in January 2021, when the shorted percentage exceeded 226% of the float!
Avg Vol (3 month)
Avg Vol (10 day)
% Held by Insiders
% Held by Institutions
Shares Short (Jan 15, 2021)
Short Ratio (Jan 15, 2021)
Short % of Float (Jan 15, 2021)
Short % of Shares Outstanding (Jan 15, 2021)
Shares Short (prior month Dec 15, 2020)
The Extreme Potential Risk of Selling Short: GameStop
Some people claim that the risk for selling short is unlimited. Well, it's not unlimited. No stock is going to rise to infinity. I say the risk is unknowable, but it can certainly be substantial, many times any potential profit, even if it is not unlimited.
To illustrate the potential risk of short selling, consider GameStop. At the start of January 2021, its share price was less than $18. Before the end of that same January, it reached $483 per share! Some investors noticed that a large percentage, more than 100%, of the float was sold short, so some people used Reddit at wallstreetbets to advocate buying the shares to increase the price to squeeze the short-sellers. And buy they did. Some bought the stock, some bought options on the stock, but both purchases increased the stock price. Buying the stock obviously increased the price by increasing demand, while buying calls on the stock also increased demand, because it forced the market makers who sold the calls to buy the stock to hedge their risk. Forcing market makers to hedge their risk is what is sometimes called a gamma squeeze, because option traders and market makers use delta and gamma to measure the changing risk of a portfolio consisting of stocks and options on those stocks as the stock price changes, and to measure how the portfolio must be reallocated to mitigate that risk. As more calls are sold, market makers must buy more stock to offset the risk. As the price rose, demand also increased from short-sellers who could not meet margin calls, causing the price to rise higher, causing even more demand.
Now, if you had sold GameStop short at $18 per share, your maximum profit would be $18 if the stock dropped to 0. But if you were forced to buy at $483 per share, your loss would have been almost 27 times your highest potential profit! But, you argue, I would have waited until the price dropped again. The problem is that your broker may have forced you to buy the stock because the original owners called back their stock, but your broker could not borrow more shares from another broker, because the shares were in such high demand, which is far more likely when the stock price is extremely high because of the extreme percentage of shorted stocks over the float. Thus, a forced repurchase may well occur when your loss would be greatest!
Consider your margin requirement. If you had sold short 1000 shares at $18 per share, then your initial equity requirement (assuming 50% initial margin requirement) would have been $9,000 (= 50% of the $18,000 stock value) and your account would have a credit of $18,000 from the short sale. After the price zoomed to $483 per share, your equity requirement would have been much greater. First, let's assume that this happened suddenly, to simply the math. In actually, you would have had to respond to a series of margin calls. To verify, stepwise, assuming only one margin call when the stock peaked:
Calculate the additional equity deposit required after a margin call on GameStop to satisfy the minimum maintenance margin requirement of 30%:
- Initial Account Value after Shorting Stock = Deposit + Money Received from Shorted Stock = $9000 + $18,000 = $27,000 = Credit Balance
- Current Account Value after Stock Peaks = $27,000 − $483,000 = −$456,000
- Required Equity After Stock Peaks (assuming 30% minimum maintenance margin requirement) = $483,000 × .30 = $144,900
- Margin Call Amount = Required Equity − Current Account Value = $144,900 − (−$456,000) = $120,750 + $456,000 = $600,900
Verify margin percentage after depositing an amount sufficient to satisfy the margin call:
- Account Value = $600,900 + $9,000 + $18,000 = $627,900
- Equity = Account Value − Market Value of Shorted Stock = $627,900 − $483,000 = $144,900
- Minimum Maintenance Margin Requirement = $144,900/ $483,000 = 30%
Not many people could afford to post an additional $600,900 quickly — or glacially slowly, for that matter — to satisfy the margin call. And if your broker had closed your short at its peak price because you could not meet the margin call, then you would have lost $456,000, more than 25 times your maximum potential profit. Furthermore, because of the extreme volatility of the stock, your broker may well force you to post much more than what would be necessary to satisfy the 30% equity requirement. The 30% is simply a lower limit imposed by regulations. Brokers may set it higher, and they will if the risk is substantial. So you may end up posting much more for collateral, especially if you want your account to be unrestricted. Moreover, additional margin interest will be assessed on the increased market value of the shorted security. And you assumed this risk for a maximum profit of only $18,000! Your loss is not unlimited, but, unless you are a multi-millionaire, it may not make much of a practical difference!
Finding the Short Interest for a Security
Short interest is the total number of shares sold short, but not repurchased to cover the short positions. Various financial publications publish the short interest on major exchanges. Pursuant to FINRA Rule 4560, the stock exchanges and other member firms report short interest and related information twice monthly, usually on the 15th and the 30th of the month. Most financial publications also rely on these reports, so their statistics would be updated no more than bimonthly. You can also find short interest for individual securities at the stock exchanges where the securities are traded.
As noted above, Yahoo Finance provides substantial information for short interest, including average volumes over 3 months or 10 days, shares outstanding, float, the number of shares short, short ratio, short percentage of float and the short percentage of outstanding shares as well as the number of shares short the previous month.
MarketBeat reports shares sold short, dollar volume sold short, shares sold short the previous half-month, volume change, percentage change, the percentage of float, the days to cover, and average daily volume. It also has tables for the largest short interest positions, and the largest increases and decreases in short interest. These tables can be sorted by clicking the column headings:
- Largest Short Interest Positions
- Largest Increases in Short Interest
- Largest Decreases in Short Interest
Short Interest Statistics, Potential Indicators of Market Sentiment
Because investors sell short to profit from expected price declines in the shorted securities, or they want to hedge their positions because they think a price decline is a good possibility, many investors look at the total short interest as a good indicator of market sentiment.
The short-sale ratio (also, short ratio), is the total number of shares shorted, but not covered, divided by the average daily volume of all shares traded on the exchange.
|Number of Shares Shorted, but Not Covered|
|Average Daily Volume of All Shares Traded on Exchange|
Note that while the numerator of the short ratio increases with short interest, the denominator, the average daily volume for that month, is not related to the short interest, and, therefore, the short ratio may actually decline when the short interest increases, which would occur when the average daily volume increases more than the short interest — and vice versa. Note, also, that, for the same reason, the short ratio does not quantify the short interest.
Another statistic that may indicate bearish sentiment is the days-to-cover ratio (a.k.a. short-interest-to-volume ratio), which compares the number of outstanding shorted shares to the average daily trading volume of the stock as an estimate of how many days of normal daily trading volume it would take to close all the short positions.
Days to Cover Ratio = Number of Shorted Shares ÷ Average Daily Traded Shares
Some investors, however, consider a large short interest to be a bullish sign, because the short sellers must buy the shorted security at some point, favorably impacting its price. This is sometimes called the short interest theory, or the cushion theory. Technical analysts consider a short position that is twice the average daily trading volume to be a very bullish sign, and a good possibility for a short squeeze, which results when short sellers buy to cover their position, raising the stock price, which, in turn, causes more short sellers to cover their positions, thereby raising the stock price even more.
Investors also consider more specialized short-interest ratios. The odd-lot short-sale ratio (aka odd-lot selling indicator) is the total of odd-lot short sales divided by the total odd-lot sales.
|Total Odd-Lot Short Sales|
|Odd-Lot Short-Sale Ratio||=|
|Total Odd-Lot Sales|
This supposed prognosticator is based on the odd-lot theory, based on the supposition that people who buy and sell odd lots (less than 100 shares of a round lot) are novice investors, and are acting in direct opposition to true market conditions. Thus, when odd-lot selling is high, then the market has bottomed, and it's time to buy, and vice versa. No evidence supports the odd-lot theory, but it may be true because investors believe it, and act accordingly.
The member short-sale ratio, using similar, specious reasoning, is supposed to be the true market indicator, and there may be a grain of truth to this. After all, if anyone would know the market, it would be the members of the NYSE who — specialists, floor traders, and off-the-floor traders — specialize in the particular securities that they sell short. The member short-sale ratio is the total shares sold short in the accounts of the NYSE members in 1 week divided by the total short sales outstanding in the same week.
|Total Shares Shorted by NYSE Members in 1 Week|
|Member Short-Sale Ratio||=|
|Total Short Sales Outstanding in Same Week|
The member short-sale ratio is published weekly in The Wall Street Journal and Barron's.
The specialist's short-sale ratio is computed in the same way as the member short-sale ratio, but only includes the accounts of the specialists on the NYSE.
|Total Shares Shorted by NYSE Specialists in 1 Week|
|Specialist Short-Sale Ratio||=|
|Total Short Sales Outstanding in Same Week|
Some short sales are made to provide an orderly market in the securities assigned to the specialist — one of their duties — but many investors, especially technical investors, use this as a prognosticator of the markets.