Confused about Short Selling? Everything you need to know in 3 minutes
A friend recently asked me how it was possible for more shares of stock to be shorted than the number of shares that are available to trade on the market. That shouldn’t be possible, right? But it is! And it happened to GameStop earlier this year.
I figured that I would write a short piece (ha ha) discussing short selling and how it works. This post assumes some basic knowledge of finance. I hope that this is helpful.
TL;DR: Yes more shares can be shorted than are available to trade. It's rare, though. Also, shorting can be expensive and super risky.
What is shorting stock and how do you do it?
This is when you sell stock that you don’t own. First, you go to your broker and borrow (for a fee) some stock. You then take these shares and sell them into the market. Hopefully, the price of the stock goes down. You then buy back that stock (or “cover”) and make money. That stock then goes back to the broker who originally lent you the shares.
You know the old saying “buy low, sell high?” Same principle but in reverse order. Sell high, buy low.
What’s the risk in short selling a stock?
What’s the risk when you buy a stock? The risk is that the price goes down and you lose money. For example, if you buy one share of stock, for $100 and the company goes under, you lose $100. Ugh. But that’s all you can lose. Maybe the company does well, and stock goes to $1000 and you make $900. Yay!
When you short, it’s the opposite, because you want the stock’s price to go down. If the stock price goes up, you lose money. This means that shorting stock exposes you to the potential for unlimited losses.
For example, if you short a stock at $100 and it goes up to $1000? Uh, you lose $900, in theory. In reality, your broker makes you put some cash in your account (this is called “posting margin”) when you short stock. Usually, you have to post 50% of the amount that you short. So, if you short $100 of stock, you also have to post $50. This allows for some cushion if the stock price moves against you.
Let’s say you shorted at $100. The stock goes up to $135 (note that this is before the stock price has reached $150). Your broker contacts you and asks you to post more margin. This is known as a “margin call.” Can’t post more cash? The broker will buy back the stock on your behalf and close the trade. In this case, the broker buys the stock back at $135. You shorted at $100 and lost $35 plus whatever fee the broker charged you to borrow the stock. Sigh.
So, there are potentially unlimited losses, fees and I’d have to post cash. Why would I short a stock?
Well, lots of reasons. Maybe you think a stock is over-valued or a company is a fraud. Maybe you want to or need to hedge some trade. For instance, maybe you work at a hedge fund. Some hedge funds let you lose 20% or 30% without firing you because they are trying to double their money. A lot of hedge funds will fire you for losing like 5% - 10% because they are trying to make low volatility returns.
Maybe you work at the latter kind of hedge fund, and you like Microsoft stock. Just buying Microsoft stock could be risky, because if it goes down 10% you might be out of a job. So, you buy Microsoft and then short some stock that’s in the same industry or is a competitor like, uhh, I don’t know, IBM. In this case, all you care about is that Microsoft stock performs better than IBM stock.
That sounds like a hard way to make a lot of money.
Yup. But that’s for another post.
Ok, whatever. Let’s go back to borrowing stock. Where do the brokers get the stock from?
Every stock owner is a potential lender. Lenders can be any person or institution like insurance companies, mutual funds, ETFs/index funds or people like you and me. Stocks are usually pooled together and lent through brokers. The largest brokers are banks, like JP Morgan or Goldman Sachs.
Brokers get shares from these pools and lend them to people who want to short stock, like you and me or (mostly) hedge funds. These shares are lent for fees that get shared between the broker and lender. Stocks that are widely held can be cheap and easy to borrow. For other stocks, these fees can be quite high. Some stocks, like GameStop, might become hard to borrow as the trade becomes more crowded (ie. a lot of people are short) and remaining lenders want higher fees to lend whatever is left or raise their fees to existing borrowers. At one point, the stock borrow fee for GameStop was as high as 130%.
That’s right, if you borrowed $100 of GameStop stock, you would have to pay about $10 a month just to borrow the stock. This can make shorting stock for any extended period of time expensive if those fees remain high. Think about these borrow fees as a “price” at which to borrow stock. Prices go up and down according to supply and demand, right? So can stock borrow fees. So not only are you paying to borrow the stock, but the stock price also needs to go down!
By the way, a lender can “recall the borrow.” This is when the lender tells the broker that it wants its lent shares back. The broker then tells the borrower, who is short, that it needs the stock back. This leaves the borrower (the hedge fund or you/me) with two options. Either the borrower finds another broker to lend it shares, or as a last resort, goes to the market and buys back stock. The latter is known as “short covering”. Borrowers can go to great lengths to avoid this since buying back stock can help the stock go up. Which leads to more short investors to also buy back stock to cut their losses. Which can lead to prices rising more. This feedback loop is called a “short squeeze.”
Ok, you still haven’t gotten into how so much stock can be shorted, like it was with GameStop. Like how can more shares than the actual float be shorted?
Oops, my bad. A company’s shares outstanding are all of the shares the company has, and this includes shares that can be traded in the stock market (known as “floating stock” or “the float”), as well as shares held by insiders (company management). If you take the total shares outstanding and subtract out the shares held by insiders, you have the float.
Let’s say that the float is 100 shares and that all 100 shares can be lent out. That means that the owners of the 100 shares have agreed with their broker that they can lend out their shares. I want to short this stock, so I go to my broker, borrow these 100 shares and sell them into the market. But when I short sell those shares, someone has to buy them. So, let’s say that you buy them. And you have an agreement with your broker that it can lend out your shares. What do we have now? The original person has his/her 100 shares. I borrowed and shorted them, so now 100 shares are short. You bought the 100 shares. And then you lent out those shares for the next person who shorted them. Even though there are only 100 shares outstanding 200 shares have been sold short.
Wait, that’s crazy. Does this happen a lot, where more than 100% of the float is shorted?
Nope. According to a Goldman Sachs report that is cited here, it’s only happened 15 times in the last ten years. The market is a big place with lots of different investors.