Reduce the High Risk of Shorting Stocks

Updated on January 27, 2018
Daniel Mollat profile image

I’m a retired business executive who now devotes most of my free time to trading stocks and stock options in the stock market.

What is short selling?

Short selling a stock is the practice of selling a stock that you don’t own. How is it possible to sell stock you don’t own? You borrow the shares from a third party. The third party is usually your stockbroker who takes the shares out of another client’s account, the third party being on a margin arrangement. You then immediately sell the borrowed shares at the current market price with the intention of buying it back at a future date at a lower price than you sold it thereby affording you with a profit in the process. You make money when the price of the stock declines but you lose money if the stock price appreciates and you have to buy it back at the higher price.

Shorting stocks, or selling stocks short, is a very risky trading strategy but nevertheless practiced by many stock traders. The practice is especially more popular when the market is on a declining trend.

Person reacting to shorting gone bad
Person reacting to shorting gone bad

Let’s take a trip back in time to the year 2014. Prices of crude oil have been steadily falling and with it so do the stocks of petroleum producing companies. You look at Chevron and you note its stock price has steadily gone down from around $130 in July to $117.50 in September. You feel strongly that with the world awash in oil, crude prices will continue to drop in the foreseeable future and so will Chevron's stocks per as well as most other petroleum companies. You contact your broker and tell him you want to short Chevron stock by selling the shares at its present market price of $117.50. Being that you don’t own any Chevron shares the broker borrows the shares from one of its clients and lend them to you. You borrow a total of 100 shares and sell them at the current price of $117.50 thereby generating a cash intake of $11,750. Crude oil prices continue sliding for many months until in April 2015 it starts to make some recovery. By this time the price of Chevron stock had gone down to $106. Fearing this might be the beginning of a price recovery you buy back the shares at its current price of $106 and pay the total amount of $10,600 and return the shares back to the broker. You just made a profit of $1,150 for a period of nine months.

Of course, there are costs to you for doing short sales such as interest charged by the broker for the use of the borrowed shares plus other small charges like commission and fees which, while not significant, can add up. Your biggest cost would be the maintenance margin deposit required by the broker to initiate such transaction. Maintenance margin deposits can vary widely depending on the stability of stock being traded as well as other market considerations such as volatility of the market. Assuming the margin required for short selling Chevron was 30% of the value of the trade, the capital needed to initiate the short sale would be $3,525 (30% of $11,750) which you needed to have on deposit with your broker. Your $1,150 profit in April 2015 represents a 32 percent return on your investment – the amount deposited to satisfy the margin required. Neat huh?

Now here is where it’s not so neat by looking at another example. Let’s go to September 28, 2017. For some reason, you believe Zogenix, Inc. (ZGNX) is a good stock to short at the current price of $12.80. You instruct your broker to sell short 700 shares of SGNX for a total cash intake of $8,960. Since this is a small cap company your broker requires you to put up 100 percent maintenance margin or the full amount of $8,960. The following day, September 29, Zogenix announces that its main drug product has had excellent results on patients. The stock price zooms to $35. You panic and decide to close the position by buying back the shares at this price. You now have to shell out $24,500 to close the position and return the shares to the broker. You’ve just sustained a net loss of $15,540. This is why shorting stocks is considered a very bold trading strategy with a very high potential for risk.

The power of options

When one is in a situation of wanting to take advantage of a falling market, don’t short stocks. Buy put options instead! The potential for large profits is still present but without the potential for the great risk of unlimited losses that short selling can create. Buying a put option gives you the right but not the obligation to sell stock and this is a far more conservative method of gaining an entry into a down-trending market.

As I write this report General Electric (GE) is priced at $23.36 and has been on a continuous downslide since the early part of this year, 2017. One could short the stock but it has been sliding now for so many months that it just might possibly turn around and start an upward trend. This is a classic case where it makes more sense to buy puts instead of shorting the stock. To short GE you would need to put up 30 percent margin deposit on the value of the shares you borrow. Assuming you have $4,000 cash in your broker account you could borrow GE shares to the tune of $13,300 (using 30% margin) which at the current price would allow you to short 570 shares. But instead of shorting you decide that buying puts would be less risky. You then allocate $1,000 of your present cash balance to purchase December puts with a strike of 23 at a price of $0.70. Buying 14 contracts enables you to control 1,400 shares (100 shares per contract) of GE stock for a total investment of $980 (1400 x .070 option price). This is your total money at risk. If GE does, in fact, start turning around and the price goes much higher than your entry price of $23.36 you cannot lose more than $980. On the other hand, if you short the stock and it goes on an upward trend from $23.36 your losses would spiral without letup for as long as the stock continues climbing.

If GE continues on its declining trend your options stake would profit in either of two ways. As the stock price drops the December 23 puts which you bought at $0.70 would start appreciating fast. Suppose the stock goes down to the level of $20 your puts could rise to as much as $2.80 - $3.00 depending on the remaining time left to expiration. This is about 400 percent increase from your entry of $0.70. The other way to profit from your puts is to buy 1,400 shares of GE at the current price of 20 and simultaneously exercise your put option to sell the stock at its strike price of $23. Either way, you make a large windfall.

One last item to consider is that to qualify to engage in short selling of stocks there are very stringent conditions imposed by securities regulators as well as your brokerage firm. If you are not a large and important client of the brokerage with a considerably high equity base you will most likely not qualify to do short selling. But almost everybody and anybody can buy puts with even a small account with your broker.

DISCLAIMER

Any and all information pertaining to trading stocks and options including examples using actual securities and price data, are strictly for illustrative and educational purposes only and should not be considered as complete, precise, or current. The writer is not a stockbroker and as such does not endorse, recommend or solicit to buy or sell securities. Consult the appropriate professional advisor for more complete and current information. Options involve risks and are not suitable for everyone.

© 2018 Daniel Mollat

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