short selling

The Mechanics of Shorting a Stock

With the return of volatility, there is money to be made finding overvalued stocks and putting on a short sale trade. When you short a stock, you sell borrowed shares with the hopes that the stock price will decline. When it declines, you can buy the shares more cheaply, and return the shares to the broker. While this transaction seems easy to conceptualize, there is a dance that needs to take place for this trade to be processed. It is worth taking a few minutes to understand what goes on behind the scenes at your broker.

Before you can place a short sale, your broker needs to allow you to do short sales. Usually the broker will want to ascertain that you are a more sophisticated investor, and understand the inherent risks and costs of short selling. Many brokerages will provide you with a brief online video that spells out the risks  of this type of transaction, others provide a document that outlines the risks and costs that you need to sign.

There is yet another prerequisite before you can make your trade. You must be cleared to take on margin debt. This may surprise you, but when you short a stock, it actually involves borrowing the stock (and the cost of that stock), hence you then owe interest on that loan. Whether the broker provides the loaned stock directly or through another broker, there are costs associated with this process.

Finally, you are ready to trade! You put in your ticker and indicate to your broker that you want to sell it short.  At that point:

  • The broker loans you the number of shares
  • Puts them into your account
  • Sells them on your behalf
  • Deposits the money from the sale into your account

While it is nice to have the money, at this stage, you have now started a debt clock ticking. You are paying interest on the borrowed shares.

When the stock price (hopefully!) declines, it is time to close out the position. When you close the position, everything happens in reverse. You buy shares on the open market, and pay back the broker with these shares. At that time, you are no longer incurring interest expense. If the stock has declined enough, you have earned a profit from the difference between the price you sold the shares and the price that you bought them back. You additionally have to account for interest you paid the broker AND the interest that you made on the money you got from the initial short sale.

Profit = (Price of Sale from short sale – Price of Sale from replacing the shares) – net interest paid to the broker + interest that you made from the funds of the short sale – 2 broker transactions fees.

At the end of the day, this is a pricey transaction relative to just buying shares. So make sure you have a good reason to go short.