Last Updated on 7 April, 2022 by Samuelsson
While short-selling a stock offers a way to make money when the price trend is downward, it is not as straightforward as placing a sell order on a futures contract. There are many things to consider, such as how it works and how long you can short-sell a stock.
There is no limit to how long you can hold a short position. However, you should understand that the risk of upward price movement is limitless, which is why many short-sellers don’t hold their positions indefinitely. You can short a stock as many times as you want. But you have to borrow the stock to short anytime you want to short.
We will discuss this under the following subheadings:
- What does it mean to short-sell a stock?
- How short-selling works
- How long can you hold a short position?
- Can you short-sell after hours?
What does it mean to short-sell a stock?
Short-selling a stock means borrowing and selling a stock you do not own with the hope that the price would fall so that you buy it back and make some profits. So, it is an investment or trading strategy that speculates on the decline in a stock or other security’s price.
Being an advanced strategy, short-selling should only be undertaken by experienced traders and investors. While experienced traders may use short selling as speculation, investors or portfolio managers may use it as a hedge against the downside risk of a long position in the same security or a related one. Speculation carries the possibility of substantial risk and is an advanced trading method, but hedging is a more common transaction involving placing an offsetting position to reduce risk exposure.
Unlike buyers who bet on the price of a stock going up, short-sellers bet on a drop in the price of the stock. You should know that short selling has a high risk/reward ratio: while it can offer big profits, the potential for losses is limitless because the stock price can continue rising indefinitely.
How short-selling works
In short selling, a trader spots a stock he believes would decline in price in the near future. He then borrows some shares of the stock from his broker-dealer and sells, hoping to buy them back for a profit if the price declines. If the price does decline, the investor sells the borrowed shares to buyers willing to pay the market price and pockets the difference between the price he sold and the price he bought.
However, if the price of the stock rises after buying, the trader would buy it back at a higher price than he bought it. Note that the risk of loss on a short sale is theoretically unlimited since the price of any asset can climb to infinity.
How do you borrow a stock to short-sell?
You don’t just borrow a stock to short; you must have a margin account to be able to borrow a stock and sell. So, the first thing to do is to open a margins trading account with your broker. The process of locating shares that can be borrowed and returning them at the end of the trade is handled behind the scenes by the broker.
While opening and closing the trade can be made through the regular trading platforms with most brokers, each broker will have qualifications the trading account must meet before they allow margin trading. Another thing is that you have to pay interest on the value of the borrowed shares while the position is open. So, you should make sure that your profit potential is big enough to cover the interest and still make you profit.
Short selling interest rate
To sell shares short, your broker borrows equivalent shares on your behalf. The stock loan agreement through which these shares are borrowed requires that your broker provides the lender of the shares with cash collateral for the loan. The amount of cash collateral is based on an industry-standard calculation of the value of the shares called the borrowing rate.
The borrowing rate is a floating one and can change throughout the day up to 2 p.m. ET. Rates fluctuate based on the security’s market value, demand, and available inventory. However, before entering a short position, you’ll receive a message outlining how much it would cost per day to borrow the selected stock. If you accept the payment and trade, your order will be sent to the exchange, and you will be charged for each full day you hold the short position. Also, if fees increase beyond the amount you’re willing to pay, all you will have to do is buy to close your short position before 5:30 p.m. ET to avoid being charged.
Short selling rules
The Financial Industry Regulatory Authority, Inc. (FINRA), which enforces the rules and regulations governing registered brokers and broker-dealer firms in the United States, the New York Stock Exchange (NYSE), and the Federal Reserve have set minimum values for the amount a trader must have in a margins account when shorting a stock. This is known as the maintenance margin: when the account value falls below the maintenance margin, more funds are required, or the position might be closed by the broker.
How to get out of a short position
You get out of a short position by buying the exact volume of the same stocks. You can do this by buying at the market price or by setting a limit buy order to buy at a specified price level or lower.
Short selling example
Let’s say you believe that Stock Q, which is currently priced at $70 per share, would fall to $50 in the next 2 months. If you have a margins account, you can borrow the stock (say 100 shares) via your broker and sell it at the current price. If, in the next month, the stock tanks to $45 per share, you can buy it back at $45 and make close to $2,500 in profit.
How long can you hold a short position?
There is no time limit on how long you can hold a short sale. You can hold a short position indefinitely.
However, there are some situations where the short may be mandatorily covered by the broker before you close the trade. This is when you get a margin call and cannot deposit more funds to support your trade. The broker will liquidate the short position.
Can you short-sell after hours?
Yes, you can short-sell during after-hours. But it comes with higher transaction costs. Only a few traders try to short the after-hours market. But those that do can be very aggressive because of the reduced liquidity during that period.