How Does Short-Selling Of Stocks Work?

There are many factors to consider when searching for new growth stock ideas such as estimate revisions, PEG ratios, and earnings growth. However, it is also important to be on the look-out for potential red flags so you can avoid those big losers that can kill a portfolio’s return. One such pitfall is a high “short interest”. What is short interest and how can it be helpful to you?

Shorting-Defined

First of all, it would help to define “selling short”. Essentially, short selling is the opposite of buying stocks - it’s the selling of a security that the seller does not own, done so in the hope the price will fall. Basically, it is the reverse of “going long” or buying a stock with the hopes of selling it at a higher price for a profit. Quite simply, short sellers hope to profit from falling stock prices.

Are Shorters Smarter?

Short interest is the total number of shares of a particular stock that have been sold short by investors but have not yet been covered or closed out. If a stock has a high short interest, many investors believe that the stock will fall.

One common perception is that short-sellers know something that the rest of investors don’t. There is little actual evidence to prove whether this is true or if it is false. However, a high short interest ratio is a sign that you should do more research to make sure you fully understand the potential risks associated with the stock before you invest in it.

Don’t Be Teased By The Squeeze

One reason many investors speculate in stocks with high short positions is the prospect of the “short squeeze”. A short squeeze occurs when short sellers are scrambling to replace their borrowed stock thereby increasing demand and decreasing supply, forcing prices up. Short squeezes tend to occur more often in smaller cap, aggressive growth stocks, which have a very small float (supply), but large caps are certainly not immune from this situation. Unfortunately, however, this is a very difficult phenomenon to predict. When it works out, you can make a ton of money as the stock explodes higher, but these occurrences are few and far between and usually not worth the risk.

Why Risk It?

A high short-interest stock should be approached for buying with extreme caution but not necessarily avoided at all cost. Short sellers (like all investors) aren’t perfect and have been known to be wrong from time to time. However, there are over 10,000 stocks that are publicly traded in the United States, so there is bound to be one that meets your fundamental criteria, which does not have a bulging short interest. The logical question becomes, “why take the risk?”

Posted in Categories: Contributor, External Research, Stocks.

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Comment by Roy Zimmerhansl

2008-10-04 05:55:27

The only caveat I would add to this process is that the risk reward dynamics for a stock that has already had a heavy decline are changed.
For example, a stock trading at $20.00 has a maximum short selling gross profit of $20.00. If that stock drops to $2.00, there is a strong temptation to jump on the bandwagon and short it all the way down to zero.
Both have in theory an unlimited loss if the stock rises.
However, there is a much greater risk that the $2.00 stock might go to $4.00 than the $20.00 stock moving to $40.00.
Outside influences can have a dramatic impact on the price movement of the stocks such as a takeover offer that comes out of the blue, an unexpected short selling ban, or even a the supply of stock available for loan.
Definitely a strategy for consideration, but as suggested, one that needs analysis.

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Comment by ciscokid1970

2008-10-09 11:33:53

The one thing I do not understand is how short-selling makes real money?

Allow me to explain. some company call it XYZ is at $20 per share and going down. Someone places a short sell at 15 for 200 shares.

So if I understand this correct it means you are selling it at $20 before you own it…and when it drops to $15 you will buy 200 shares.

But how is it that someone is buying these shares at $20 when they are not yet available? Is there some max amount of time you have to deliver your shares?

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Comment by Roy Zimmerhansl

2008-10-10 15:26:43

Hi ciscokid1970

What happens is that in order to see it at $20 you have to borrow it from someone so that you can make the delivery to the person that bought it from you, and so that you can collect the cash proceeds from the sale.

Then when/if it drops to $15 you buy it back and when you actually get the stock, you return it and close the loan.

You pay a fee to the lender for borrowing the stock in the same way that you pay a fee to your bank for borrowing cash.

Does that make sense?

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Comment by Alvaro

2009-03-12 05:23:49

How do you know which stocks have a short interest and which stocks don’t? How is this measured?

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Comment by Roy Zimmerhansl

2009-03-13 02:34:20

The NYSE and NASDAQ both publish the data, but you don’t really need to go there to find the information. The story is always picked up in the press. Here is an article on the latest numbers.

http://www.reuters.com/article/etfNews/idUSN1054934420090310

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