What is Short Selling and How Does It Benefit the Market?

Short selling is a way to profit from companies whose stock price has moved higher than its fundamentals support. Most economists believe that short sellers play a vital role in increasing market efficiency by enhancing price discovery and increasing liquidity.

Often maligned as a tool of predatory traders, short selling has gained legitimacy due to the participation of institutional investors such as hedge funds and quantitative trading firms.

Short selling isn't bad—it's just misunderstood.

What Is Short Selling?

Short selling is a trading strategy in which a company's shares are borrowed and sold, then repurchased and returned to the lender when the stock's price falls. It is a way to take a bearish position on a stock or a method of hedging a long position. Short sellers profit from bad management the same way long traders profit from good management. Short selling is also a way to profit during market downturns.

In simple terms, short selling goes something like this:

1. Identify a company whose stock (in your opinion) is trading above fair value.
2. Borrow shares in the company from your broker.
3. Sell the shares on the open market.
4. When the share price falls to your target price, close the short by repurchasing the shares you sold.
5. Return the shares to your broker and pocket the difference (minus fees and interest.)

Shorting a stock is more complicated in actual practice.

1. First, establish a margin account with your broker. This will require at least $2,000 in initial margin funds.
2. Before the broker will loan you the stock, you must have half the purchase price in your margin account (giving you 50% leverage). If you borrow $1,000 worth of stock, you must have at least $500 in your margin account.
3. Place the short order with your broker.
4. The broker will locate the shares, sell them, and put the $1,000 in your margin account.
5. When the stock falls to your target price, you purchase the same number of shares that you borrowed using the money in your margin account that you received when the borrowed shares were sold.
6. The shares will automatically be transferred from your account to your broker.
7. The difference between the borrowed and repurchase prices (minus interest) is your profit.

Margin Rates and Borrowing Fees

Two types of expenses are incurred when short selling: margin rates and borrowing fees. The margin rate is the interest rate the broker charges on the money you borrowed to buy the stocks you sold short. The same margin rate applies to all short positions in your account. It is calculated daily but charged monthly.

Borrowing fees are calculated individually for each short position. Also known as the "short stock interest rate" or "stock loan fee," it is based on the difficulty of borrowing the shares you've shorted. Stocks that are hard to acquire or have a high percentage of shorts will have higher borrowing fees.

Borrowing fees are expressed as an annual percentage rate but are charged daily. They are usually much higher than margin rates and are more likely to change according to daily market conditions and the price action of the stock in question.

One other expense concerns dividends. If the stock you sold short pays a dividend before you close the trade, you must pay that same amount to the broker you borrowed the stock from. This is automatically taken from your margin account.

How Short Selling Benefits The Market

Short selling benefits the broader market in several ways. It enhances price discovery, increases liquidity, and dampens volatility.

Price Discovery

Fundamental stock shorting, by definition, finds overlooked adverse facts about a company that are not reflected in its stock price. Shorting the overvalued stock helps incorporate this information into the share price more quickly, moving prices closer to the company's intrinsic value.

This can be especially helpful when a company is discovered committing fraud or concealing damaging material information. At a certain point, short sellers will start buying into the price drop to close their positions, providing demand when the company sorely needs it.

Studies show that higher levels of short selling activity improve a stock's intraday price efficiency by more rapidly countering overbought conditions. Without short selling, price discovery on overvalued stocks is limited to buying shares or selling those you already own, leading to an upward bias in the stock's price.

This can be compared to a post on a website that only allows upvotes. The post's approval can only go up, no matter how many people disagree with it. Short selling is the market's version of a downvote, moving prices toward a more accurate reflection of trader sentiment.

Liquidity

Short selling increases liquidity by selling shares that ordinarily would not be available during rallies and providing willing buyers when prices fall. This helps keep bid/ask spreads narrow, improving price discoverability and balancing supply and demand.

A sudden drop in a stock's price decreases liquidity as everyone wants to sell, but no one wants to buy. Short sellers step in as buyers to provide that liquidity. The same applies to a sudden price spike. Illiquidity pushes prices higher, as no one wants to sell. Once again, short sellers step in, this time to provide extra shares to the market, improving liquidity.

Volatility

The basic premise of short selling, selling high and buying low, also helps tamp down volatility by building a ceiling on big rallies and a floor on big selloffs. While other traders push prices higher, the shorts sell into the rally to increase their profits after the stock turns down. As prices fall, more short sellers buy to close out their positions and book profits. This helps prevent, or at least hinder, the formation of stock bubbles.

Short sellers help lessen the shock of adverse information about a company being revealed by quickly getting its share price trending toward the new lower fair value.

Recap

This is just a simple overview of how short selling works and the benefits it brings to the market as a whole. Hopefully, we have dispelled some of the misunderstandings about short selling and shown the recognized benefits it has for particular stocks and the market as a whole.