Shorting a Stock - The Definitive New Zealand Guide to Betting Against a Stock Price Rise
Our guide explains short selling, how you can short a stock and the risks associated with short selling. We'll also list important facts you need to know and the most frequently asked questions New Zealanders have when shorting stocks.
Updated 10 May 2023
Summary
Over guide covers:
Know This: If you want to short stocks but don't like the idea of "unlimited liability" if the price of a share rises, a selection of inverse and short ETFs are available on US markets. You can buy into these using Hatch, Sharesies and Stake. An inverse ETF is set up so that its price rises (or falls) when the price of its target asset falls (or rises) - the performance is inverse to the asset it’s tracking. For example, an inverse ETF may be based on the NASDAQ index; The ETF is designed to rise as the NASDAQ falls in value.
If you'd like to short New Zealand companies, short selling is common in Australia and many New Zealand companies list on the ASX. You can see a daily record of short sales vs total shares on issue here.
Summary
- With the democratisation of financial education and investing and an rise in interest in stock trading, there has never been a better time to learn about investing. However, with many complex markets and trades happening worldwide, it can be extremely difficult to try and understand what's happening.
- Financial events like the Gamestop and AMC sagas surprised many, and many wonder what caused this. At the root of these fiascos was short selling.
- In one sentence, short selling is a trading method that lets you make money as the price of a stock falls. It is highly risky and the losses can be unlimited.
Over guide covers:
- What is Short Selling?
- Why Do Investors Choose to Short Stocks?
- How Can I Short a Stock?
- Understanding the Risks of Shorting a Stock
- Must-Know Facts
- Frequently Asked Questions
Know This: If you want to short stocks but don't like the idea of "unlimited liability" if the price of a share rises, a selection of inverse and short ETFs are available on US markets. You can buy into these using Hatch, Sharesies and Stake. An inverse ETF is set up so that its price rises (or falls) when the price of its target asset falls (or rises) - the performance is inverse to the asset it’s tracking. For example, an inverse ETF may be based on the NASDAQ index; The ETF is designed to rise as the NASDAQ falls in value.
If you'd like to short New Zealand companies, short selling is common in Australia and many New Zealand companies list on the ASX. You can see a daily record of short sales vs total shares on issue here.
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Your guide to shorting a stock is sponsored by our friends at Stake, a leading online share trading platform.
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MoneyHub Founder Christopher Walsh shares his views on shorting stocks:
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"Markets move up and down, but trying to make profits by shorting stocks at any time is incredibly risky. While you may be certain that a particular company's prospects are poor, shorting it can go wrong (and lose you a lot of money) if the company becomes a takeover bid, releases positive press, turns itself around or, for any other reason, sees it share price rise".
"I believe that, for most people, it's hard to make money picking a handful of speculative 'growth' companies to invest in - often, despite the best intentions of an investor to be a long-term holder, markets catch investors out, leading to losses. However, shorting 'bad' companies' shares is a completely different strategy, and while the returns can be high, the losses can be catastrophic". "The cases of Gamestop (as summarised by the Financial Times here) showed that even professional short sellers could lose billions when a short goes wrong, although this was an extreme case. For this reason, if you're interested in shorting, you may want to consider an inverse or short ETF, which limits the unlimited risk and has professional management and research team. "Remember, the risks are significant. As the late Bryan Gaynor said in this 2018 NZ Herald column, Short selling is a risky and expensive strategy, partly because of the cost of borrowing shares. It can lead to huge losses, as well as profits". |
MoneyHub Founder
Christopher Walsh |
What is Short Selling?
- Shorting a stock (also called short selling) is a way to profit from decreases in stock price. If you think a company's stock price is likely to drop, you can profit from this drop in price by shorting the stock (where you wouldn't otherwise be able to make money on decreasing prices if you just bought the stock). Investors with a higher tolerance to risk and speculate that a company may be suffering some short-term pressure may want to try and profit off this opportunity.
- Short selling is a trading method that lets you make money as the price of a stock falls. The standard way people make money in the stock market is to buy a stock, wait for it to rise in price, and then sell at a profit. This strategy is known as "going long" on a stock. However, this isn't the only way to profit from stock prices. You can also "go short" on a stock.
- Short selling happens when an investor borrows stock from another investor or a brokerage platform and sells them on the open market (meaning they owe the investor/brokerage a certain number of shares in the future). Investors do this with the expectation that the stock price will fall after they've sold the stock. If it does, the investor can buy back the same quantity of shares on the open market (at a lower price) and give them back to the investor or brokerage platform while profiting from the difference in price (from selling high and buying low).
- While long-term investors may buy stocks they think have the potential to grow fast and become the leader in their markets, short-term investors have a different view on stocks.
- Short selling is particularly popular with investors with much shorter time horizons, such as hedge funds and day traders. These investors may be looking at the momentum of a stock (how much it's been moving in the last few trading sessions)
Why Do Investors Choose to Short Stocks?
Investors decide to short stocks for all sorts of reasons. The most common reasons are to amplify investment returns (by taking on additional risk) and to "hedge" a position (which looks to reduce risk). We explore these in detail:
1. Short Stocks as a Way to Increase Returns
2. Shorting as a Way to Hedge Your Portfolio
1. Short Stocks as a Way to Increase Returns
- Investors short stocks to try and improve their investment returns when "going long" isn't enough risk/reward for them.
- As a practical example, assume you borrow ten shares of Apple stock from your brokerage when the price of Apple's stock is $100. You then sell these ten shares for $1,000 (ten shares * $100 per Apple share), generating $1,000.
- If the stock price drops to $50 per share after a year, you can repurchase the ten Apple shares using your $1,000 and return the ten shares you borrowed from the broker for only $500, making a $500 profit on the short sale.
- Note that in the above example, we haven't included any interest cost you would have to pay the broker to borrow the shares. While this sounds easy enough to execute, there’s much more to consider. Shorting a stock can be rife with risk and uncertainty (which we’ll detail below).
2. Shorting as a Way to Hedge Your Portfolio
- Shorting a stock can also act as a "hedge", meaning that it can reduce risk in some instances.
- For example, if you invested $1,000 into Google stock but thought investing in the US technology sector was risky, shorting can assist.
- If you just wanted to get the benefit of investing in Google, you may decide to short $500 worth of Netflix. This trading activity would mean that your "net exposure" is only $500 ($1,000 long Google - $500 short Netflix).
- If the whole tech sector went up, your Netflix position would suffer, but your google position would gain more than the loss on Netflix.
- However, if the whole tech sector started to weaken, your Netflix short would partially offset the losses in the google position.
- From the example above, shorting can be a way to reduce volatility and exposure to the other stock market positions you hold. Investors may choose short stocks to take advantage of unique macro or microeconomic conditions without exposing themselves to too much risk.
How Can I Short a Stock?
- Not every investor can short stocks. To short a stock, you need to be given the right permissions from your broker. Many investors that short stocks do so through a margin account, which lets them borrow additional funds and use their stocks as collateral.
- It's important to know that there may be restrictions on what stocks you can and can't short. Further, your account may require minimum balances for you to enter into a short position.
- If you’re shorting stocks internationally, using global brokerage platforms such as Interactive Brokers are likely to offer the tools and support you need. Specifically, these brokerage platforms are internationally recognised, have large balance sheets and are less likely to go bankrupt if anything happens to the brokerage’s risk exposure.
Shorting a Stock on the New Zealand Stock Exchange (NZX)
- The main way to short a stock on the NZX is to go through a broker, such as Jarden or Forsyth Barr.
- Full-service brokers typically have the capabilities and team to support you in borrowing and shorting stocks. They also provide recommendations and research to back up your investment thesis.
- However, most brokers will typically only work with qualified/sophisticated wholesale investors with minimum amounts you're looking to trade. In New Zealand, the NZX Participant Rules outline the key things you must meet if you're shorting a stock on the NZX. Note that the NZX can restrict or limit short-selling under certain criteria.
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Your guide to shorting a stock is sponsored by our friends at Stake, a leading online share trading platform.
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Important: Understand the Risks of Shorting a Stock
Short selling is usually reserved for experienced investors. It is uncommon for retail investors (non-experienced investors) to do it unless they are fully aware of the risks and have short-selling experience. However, some ways to increase competency in shorting stocks include:
The risks of short selling cannot be understated, and we highlight the most significant:
1. Losses are potentially unlimited when shorting stocks.
2. Borrowing shares costs money in the form of interest
- Courses in finance and investing
- Paper trading/simulated account (trading without the financial implications of real money)
- Make short trades with real money
- Learn from others who are experienced in short selling
The risks of short selling cannot be understated, and we highlight the most significant:
1. Losses are potentially unlimited when shorting stocks.
- Short selling can be extremely risky if you don’t know what you’re doing. In an ordinary stock purchase, the most you can lose is the total amount you paid for the shares. So, for example, If you buy one share of Apple stock for $100 and the company goes bankrupt, your Apple stock is worth $0, and the most you've lost is $100 (the cost of your Apple stock).
- However, your upside on buying a stock is theoretically limitless. Like the example above, Apple stock could rise to $1,000 or $10,000, meaning you can 10x or 100x your investment. This structural advantage is why "going long" and buying stocks are so powerful for long-term wealth creation. If you pick the right company, it can theoretically turn $1 into $1,000+.
- When you short a stock, it's the exact opposite. The maximum amount you can make when shorting a stock is 100%. For example, if you borrow 10 Apple stock at $100 (total value of $1,000) and the price of Apple stock goes to $0, and you buy 10 Apple stock at $0 (costing you $0) to give the shares back to the broker, the most you've made is the total amount of money you put in - in this case $1,000.
- You theoretically can't make more than you put in when shorting a stock. However, your losses are theoretically unlimited. As we've established above, stock prices can continue to increase infinitely. There's no reason Apple stock can't go from $100 to $10,000. Using the example above, assume you borrow ten shares of Apple stock and sell them on the open market, where Apple stock is currently trading at $100 per share. You earn $1,000 in cash from borrowing and selling Apple stock.
- For example, if you were expecting the price of Apple stock to fall on the next earnings report, but unexpectedly the company performed well above expectations, and the shares skyrocketed to $500 a share. Unfortunately, because you borrowed ten shares of Apple stock, you still owe the broker those shares back, regardless of the price you pay. This borrowing means you'll have to buy the ten apple shares back for $500 a share.
- From this example, what initially generated $1,000 now costs you $5,000 ($500 X 10 shares), resulting in a loss of $4,000. This loss, in theory, can go on indefinitely, meaning the longer you wait to buy back the shares to repay your broker, the higher the share price could go (and the more money you could lose) and the more interest you will owe to your broker.
- If this happens, a broker might issue you a "margin call", which requires adding additional funds into the account to make sure you can pay off your debts to the broker. If you can't, your short position will likely be closed out to ensure that the broker gets their money back (you will be forced to buy back stock at whatever the current price is while you still have the cash to do so). A margin call is a short seller's worst nightmare.
- The examples above show the inherent difficulty with shorting a stock and why a buy and hold strategy is much simpler, easier and safer.
2. Borrowing shares costs money in the form of interest
- It may seem insignificant relative to the risk of unlimited losses, but short selling isn't free. Brokers charge an interest rate to lend out stocks, and there are also initial short-selling costs for some securities in times of extreme uncertainty and volatility.
- Remember that these fees can eat away any return you generate on shorting stocks. For example, if you short a stock over one year, that generates a 10% return, but the interest rate on borrowing the stock from your broker is 7%, you only earn 3% after fees.
- So, just like you look for the lowest fee ETFs, make sure to consider the borrowing rate when shorting a stock.
Short Selling - Must-Know Facts
1. Short selling can be controversial, and many people have negative perceptions of short selling.
- Short selling is controversial, and it's not hard to see why. An ideal scenario for a short seller is that the company they're targeting goes to zero.
- Generally, people are uncomfortable with investors making an active bet that results in thousands of people losing their jobs and millions of dollars in value destruction and actively betting against other investors. Yet, when investors short a stock, this is what they implicitly hope happens.
- For example, if you had shorted Lehman Brothers stock in 2007/2008 and were confident that the stock was worthless, what ended up happening is thousands of Lehman employees lost their jobs. In addition, millions of Americans arguably lost their homes due to their practices. So while your short alone isn't likely the cause, people may still infer that you had something to do with their collapse, even if the executives at Lehman were in the wrong.
- Short sellers have been accused of hurting businesses, manipulating public opinion and spreading rumours about a company, all to push down the stock price. In addition, many short sellers are seen as hostile in the eyes of publicly traded companies. some markets and countries have banned the practice entirely
2. Short sellers are also known for shedding light on fraudulent, poorly run or risky companies.
- Short seller reports can add substantial value to existing shareholders unaware of what's happening in the company. Their deep research and pursuit of the truth can be seen as a positive (and even save money for shareholders who can exit the stock after the short report comes out).
- Some people view short sellers as an essential part of the financial markets that protect shareholders and shine a light on fraudulent companies. Others see short selling as toxic and intentionally causing hurt to thousands of shareholders, leading to lost millions of jobs. There isn't a clear consensus, but what's certain is that short selling is controversial.
3. If you're serious, you'll need to identify a clear catalyst before shorting a stock
- If you intend to short a stock you think is fraudulent or will drop in price in the short term, the way to ensure your idea is correct is to establish an investment thesis and identify a key catalyst. An investment thesis is a central idea that your trade centres around.
- For example, at the start of 2020, your investment thesis may have been that COVID-19 will mean the global economy is forced to go into lockdown, stunting the growth of retail, travel and hospitality businesses. This theory/thesis would lead you to short stocks in those sectors.
- If you did this, you probably would have made a very profitable trade. However, a key catalyst (such as COVID-19) must occur in a specific timeframe. If there isn't a key catalyst, then your investment thesis may never occur.
- Many investors that short stocks have these two components clearly articulated before they go into any short trade. If either of these things isn't established, the trade can go wrong, and you may experience large losses from your short position.
Frequently Asked Questions
We list a selection of common queries below, however short selling isn't something that many New Zealanders partake in. If there's something you don't understand but intend to short sell, we strongly suggest finding the answers to ensure you're fully informed around the risks.
Should I short stocks?
There's no right answer here. For most New Zealanders, it's arguable that the risk/reward for undertaking short selling isn't going to be worthwhile. As detailed above, the risks are extreme, and you must be comfortable taking on potentially unlimited losses. However, shorting stocks may be right for you if you are knowledgeable in an area and have identified a key catalyst and a strong investment thesis.
How risky is short selling?
Extremely risky. Short stocks are not recommended unless you're experienced, have a deep financial understanding of short selling and are comfortable taking on the level of risk associated with short selling.
What are the most common brokerages to short a stock?
If you're looking to short New Zealand stocks, going with one of New Zealand's leading brokerages like Jarden, Forsyth Barr or Craigs is likely to be an option. However, if you're looking to short overseas stocks (such as stocks on the New York Stock Exchange or the Australian Stock Exchange), international brokerage platforms such as Interactive Brokers (IBKR) (and others) will have the functionality you need. Note that many brokerage platforms will require minimum account balances, and you must undertake tests/attestations that you are experienced enough to use their products.
How does a broker calculate the borrowing rate for borrowing a stock to short sell?
Brokers typically loan stock to you at an interest rate above the current benchmark rate. This benchmark rate may be pegged to the Official Cash Rate (OCR) in New Zealand or the Fed Funds Rate in the US. They will then add their percentage margin on top as a fee (such as 1.5% or 2%) to arrive at a short selling interest rate. They may also charge an initial fee to establish the short-selling position. This fee structure will vary depending on the brokerage.
What happened to Gamestop? Was that a short-selling situation? Why did the price go up?
Gamestop started as a short position for several hedge funds on the assumption that COVID-19 would impact their business but ended up in a "short squeeze", seeing the price increase from $5 to $80 (an increase of more than 16X). It's particularly dangerous if many investors are shorting the same company simultaneously, and the "short interest" (how much percentage of the total number of shares have been shorted) gets high.
In the case of Gamestop, the short interest became greater than 100%, meaning if the short sellers tried to close out their positions, there wouldn't be enough stock to give back to the brokers. This trade, coupled with a significant number of people on Reddit who noticed this discrepancy and started purchasing the stock, caused the price of Gamestop to rocket up from around $5 to $80 in a matter of weeks.
This situation is what's known as a "short squeeze", where short sellers struggle to cover their positions and frantically try to buy back the stock on the open market to pay back their brokers, causing the price to go up, which leads to more pressure for others to cover their positions, and so on in a vicious cycle. This article sums up the origins and aftermath of the losses incurred by Gamestop short sellers.
In the case of Gamestop, the short interest became greater than 100%, meaning if the short sellers tried to close out their positions, there wouldn't be enough stock to give back to the brokers. This trade, coupled with a significant number of people on Reddit who noticed this discrepancy and started purchasing the stock, caused the price of Gamestop to rocket up from around $5 to $80 in a matter of weeks.
This situation is what's known as a "short squeeze", where short sellers struggle to cover their positions and frantically try to buy back the stock on the open market to pay back their brokers, causing the price to go up, which leads to more pressure for others to cover their positions, and so on in a vicious cycle. This article sums up the origins and aftermath of the losses incurred by Gamestop short sellers.
How long can I hold shares that I've borrowed from a brokerage?
Once you've borrowed stock from a brokerage platform, you can hold them for as long as you want, whether that's for hours or years. However, remember that every day you hold them, you'll incur interest that you need to pay back (similar to a mortgage). The rates on borrowing stock for short selling are found on the respective brokerage websites.
Additionally, the stock market generally tends to go up over time. Therefore, the longer you hold a short position, the less likely you will profit from the trade, assuming the stock market trends upwards. This imbalance is why most short sellers have a specific timeframe (usually from days to months) when shorting a stock.
Additionally, the stock market generally tends to go up over time. Therefore, the longer you hold a short position, the less likely you will profit from the trade, assuming the stock market trends upwards. This imbalance is why most short sellers have a specific timeframe (usually from days to months) when shorting a stock.
Why Would Investors or Brokerage Platforms Lend you stock?
Investors or brokerage platforms can enhance their returns from stock they already hold in their investor account by loaning the stock out to people who want to short a stock. Ordinarily, investors or brokers will offer you their shares for a fixed interest rate (usually around 3% a year). Stake, the US-focused investing platform, offers its investors the option to lend stocks and receive an interest payment. So, for example, if you asked to borrow ten shares of Apple stock at $100 a share, totalling $1,000 for one year, it would cost you $30 to borrow these shares for the entire year (3% of $1,000).
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Your guide to shorting a stock is sponsored by our friends at Stake, a leading online share trading platform.
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