short selling

Short selling is a trading strategy that operates in the opposite direction from what most investors do. While your clients might focus on buying securities that they hope will increase in value, short sellers profit when security prices decline.

This approach demands thorough consideration and research before anyone takes action. In this article, Wealth Professional Canada will explore all that you need to know about short selling.

What is short selling?

Short selling is an advanced trading strategy where an investor borrows a security they believe will decrease in value, sells it immediately, and then buys it back at a lower price. The profit comes from the difference between what they sold it for and what they paid to buy it back, minus any associated costs.

This strategy goes against the traditional investing approach that your clients might be familiar with. Most investors follow a "buy low, sell high" philosophy, purchasing securities in hopes they will appreciate. On the contrary, short sellers are betting on the opposite outcome.

While stocks are the most common securities that get shorted, exchange-traded funds (ETFs) can also be sold short. The same is true for bonds. The strategy attracts investors who want to profit during market downturns or who believe a particular company is headed in the wrong direction.

How does short selling work?

The first thing a short seller does is identify a security that they believe is overvalued. These investors conduct extensive research to find their targets. They might look for companies with products that have failed to gain consumer interest, or stocks that are underperforming compared to competitors in the same sector.

They might also examine sectors facing upcoming challenges. The research phase is critical because a short seller needs to be confident in their analysis before proceeding.

Once they’ve identified a target, the investor borrows the security from a lender. This is a vital step because you cannot short a security you don’t borrow. After borrowing the shares, they immediately sell them in the open market at the current price. The investor receives cash from this sale.

Waiting for the price to fall

Here’s where it gets important for your clients to understand the math. The investor is now waiting for the price to fall. If their analysis is correct and the price drops, they can buy back the same number of shares at the lower price.

The difference between what they sold the shares for and what they paid to repurchase them is their profit, before accounting for costs. Watch this video to learn more about how short selling works:

To learn about other investment and trading concepts, check out our Glossary page.

Sample scenario

Let’s look at a concrete example to see how this plays out. Suppose that Investor X researches a retail company and believes its stock price will fall due to declining sales and increased competition. They borrow 1,500 shares when the price is $45 per share and immediately sell them for $67,500.

If the price drops to $35 per share as Investor X predicted, they can buy back 1,500 shares for $52,500. Before costs, their profit was $15,000.

The opposite scenario is also possible. If the price rises to $68 per share instead of falling, Investor X must buy back 1,500 shares for $102,000. They now have a loss of $34,500 before costs.

But regardless of whether Investor X made money or lost money, they are obligated to return the shares to the lender.

Biggest risk in short selling

The critical difference between short selling and traditional investing is that losses in short selling can theoretically be unlimited. If an investor buys a stock, the maximum loss is the amount they invested, since stock prices cannot fall below zero.

However, there is no upper limit on how high a stock price can go in short selling. The higher the price rises, the larger the potential loss.

Can you short sell in Canada?

Short selling is permitted in Canada, but it is regulated. To short sell in Canada, an investor needs a margin account. A margin account is different from a regular cash account. It allows investors to borrow money or securities from their broker. The assets in the margin account serve as collateral against the amount borrowed.

The Canadian Investment Regulatory Organization (CIRO) sets the minimum margin requirements for securities. These minimum requirements establish how much money an investor must have in their margin account to borrow and short sell. Individual brokers are permitted to set their own margin requirements, but they must be higher than the CIRO minimums.

What are margin calls?

One important concept your clients should understand is the margin call. If the security’s price rises, the value of collateral in the account decreases relative to the debt. When the account falls below the minimum margin requirement, the broker issues a margin call.

This is a demand from the broker to fund the account to meet minimum requirements again. If your clients receive a margin call, they must either:

• close their short position
• transfer cash into the account
• transfer securities to the account

If they cannot do any of these options, the broker might force the position closed.

The margin call mechanism is a safeguard in short selling. It prevents situations where losses mount indefinitely without the investor having the ability to cover them. To know more about margin calls, watch this:

DIY investing platforms are adding margin trading, letting regular people access risky strategies that financial advisors warn against. This can lead to huge margin calls if inexperienced investors lose money.

Still, this can also be an opportunity for financial advisors. Those who get burned by margin calls might seek professional help instead of managing their money alone.

Is short selling difficult?

Short answer (pun intended): yes. The strategy requires not just research skills but also an understanding of timing, risk management, and the costs involved:

1. Predicting price movements

One difficulty is that short sellers are trying to predict a decline in a security’s price. This prediction needs to be based on research and analysis.

Your clients would need to identify companies they believe are overvalued or sectors facing challenges. This kind of analysis is more complex than simply following traditional investing strategies.

2. Managing the timing

Another difficulty lies in managing the timing. Even if an investor correctly identifies that a security is overvalued, there is no guarantee on when the price will decline. The stock might continue rising for months or even years before the price correction comes.

During this time, the investor holding the short position is experiencing losses. If they run out of patience or funds, they might be forced to close the position before their analysis proves correct.

3. Accounting for multiple costs

Managing costs also makes short selling difficult. Short selling involves several different expenses that can eat into profits. The cost to borrow shares varies depending on how readily available they are and how much demand exists for them.

If the borrowed security pays dividends, the short seller is responsible for paying those dividends to the lender. Some brokerages also charge commissions when clients buy and sell securities. These costs can reduce any profit the short seller makes.

4. Having strict risk management

The most difficult aspect of short selling is managing risk. The potential losses are unlimited, and this creates a psychological and financial burden. Your clients need to have strict risk management strategies in place and be prepared to close positions if losses exceed certain thresholds.

Getting your clients ready for short selling conversations

If your clients express interest in short selling, you need to make sure that they understand that this is a sophisticated strategy. They must fully comprehend the risks, especially the unlimited loss potential and the possibility of margin calls forcing positions closed.

Your clients should have a solid grasp of fundamental analysis and research on potential short targets. They need to learn about different valuation metrics. They should also be able to identify when a security is genuinely overvalued versus when it might simply be out of favour.

Risk management is critical. Your clients should establish a limit on how much they are willing to lose on any single position and when they'll exit a losing trade. These rules should be in place before they open a short position.

Finally, your clients should work with brokerages that offer competitive borrowing rates and low commissions. The costs associated with short selling can greatly impact returns, so selecting the right broker matters.

Has Warren Buffett ever shorted a stock?

Warren Buffett, one of the world’s most successful investors, has indeed experimented with short selling. His experience offers valuable lessons for clients who are considering this strategy.

In his early career, Buffett used short selling as a hedging tool to protect his long portfolio. He would approach institutions such as college endowments and borrow share certificates from them in exchange for a small fee.

His approach was straightforward: he wanted to short as much stock as possible to provide downside protection rather than carefully selecting individual securities to bet against.

However, Buffett has largely avoided short selling throughout his career. At the 2001 Berkshire Hathaway annual shareholder meeting, he called short selling "very painful."

Buffett acknowledged that short selling is tempting because investors encounter far more dramatically overvalued stocks than undervalued ones. But he did emphasize that shorting is "a very tough business because of the fact that you face unlimited losses."

Here’s a clip from the 2001 Berkshire Hathaway annual meeting where Warren Buffett and Charlie Munger, Buffett's business partner, talked about why they won’t short sell again:

Should clients try short selling or avoid it entirely?

Short selling is a legitimate but advanced trading strategy that offers potential profits during market downturns. Still, it comes with substantial risks that demand thorough preparation.

The key is making sure that your clients approach short selling with their eyes wide open. They need to learn the concepts discussed above, like margin accounts and margin calls, plus the various costs involved.

Because short selling is a high-risk, high-reward approach, your clients also need to accept that potential losses are not capped. For some sophisticated investors, short selling might be a good addition to their overall strategy. For others, the risks will be too great.

Either way, your clients will benefit from having a financial advisor who knows exactly what this complex strategy requires. When you know the risks and rewards, you can have better conversations about whether short selling makes sense to them.

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