Short Selling Explained: Definition & Rules

You may have heard of investors who short stocks and make significant profits in almost no time. But what exactly is shorting a stock, and what are the rules you need to know?

Shorting a stock or short selling is when an investor speculates that a stock's value will fall. Yes, that's right. Unlike many other popular trading strategies, when you short sell, you want the price of the shares to drop. 

So how does it work? You borrow shares of the stock at a higher price to sell them and buy back the shares at a lower price once the value drops. Then you return the borrowed shares to the lender and pocket the difference.

If short selling sounds like an investment strategy you're interested in, keep reading to learn more.

Short selling rules

Short selling is regulated by law, so you need to know all the rules before deciding to short a stock. From 1938 to 2007, the original short sale rule barred investors from short selling a stock whose value was in decline. The Securities and Exchange Commission SEC created this regulation to protect investments when it was considerably easier to manipulate the market. The rule only allowed short selling when a stock's value was in an uptick, the goal being to stop investors from potentially influencing the market and causing a financial crisis.

In 2007, however, this rule was appealed, allowing some investors to make massive profits during the 2008 market crash.

What are the new SEC short selling rules?

In 2010, the SEC implemented an alternative uptick rule—also known as short sale restriction (SSR)—to allow short selling to take place within certain limits only. Specifically, you can short a stock until the market price declines by 10% or more in one trading day. When a stock's value drops more than 10%, it triggers what's known as a "circuit breaker," which prohibits short selling for the remainder of that trading day and the following, too.

If you want to short a stock with a 10% price drop, the short-sale order must be higher than the bid, making the trade on the uptick.

When announcing the alternative uptick rule in 2010, the SEC said it's designed to preserve investor confidence and promote market efficiency and recognizes short selling can potentially have both a beneficial and a harmful impact on the market.

Unfortunately, illegal short selling (also known as "naked short selling") still occurs despite the SEC's regulations. Naked short selling happens when someone shorts shares that have not been determined to exist. Essentially, this means someone has sold short on shares they do not own. Naked short selling happens when individuals find loopholes between paper and electronic systems to exploit.

Understanding the process

Now that you understand the rules of short selling, you're probably wondering how to short a stock.

1. First, you need a margin account with your brokerage firm to start short selling.
2. Once you identify the stock and the number of shares you want to short, you'll typically need 150% for the margin requirement or 50% of the proceeds from shorting the stock. 
3. Your broker facilitates borrowing and selling the desired shares. To comply with SEC rules, you must declare they are short selling the shares. 
4. Your broker will borrow the sales from another client or a separate broker-dealer. According to SEC rules, brokers must adhere to what's known as the "locate requirement." In other words, they must have reasonable grounds that the security can be borrowed.
5. Once your broker sells the shares on the open market, you are in a short position and will contact your broker when you decide to close out, either because you're satisfied with the stock price or can no longer afford to keep the short position open.

What are the risks of short selling?

Short selling is known for being a particularly risky investment strategy for several reasons. Here are some of the risks to consider when you sell short.

1. Cost

To short sell a stock, you take on various costs, including the price of borrowing shares to short, the interest you pay on a margin account that's necessary for short selling, and the dividends on the shorted stock.

2. Risk-reward payoff

Compared to taking a long position, you take on more risk with a short sale. In a long position, the most you can lose is the principal amount you invest. With a short position, your potential losses are theoretically unlimited, and your gains are limited to 100% of the initial sale. When there is market volatility, you can make a quick profit, but it's possible to lose even more.

3. Going against the grain

Generally, the stock market has an upward trend over time. If you short sell, you go against long-term market trends.

4. Timing

If you decide to short a stock but the price remains steady or increases, you may not be able to afford to keep your short position open long enough for the share price to fall, as you had speculated.

5. Regulations

Due to certain market conditions, short sale restrictions can be imposed, potentially causing a short squeeze if investors rush to buy back shares of a scarce stock. You can find a current list of short sale restrictions when considering what stocks to go short on.

FAQs 

Is short selling ethical?

Some consider short selling unethical or unscrupulous practice because it bets against the stock market or aims to tear down companies.

An example of this is a short ladder attack when a fund or firm heavily shorts a stock and then attempts to drive down the share value. Although many may view short selling as unethical, the strategy allows the market to run efficiently by providing liquidity. 

Short selling can also provide the occasional much-needed skepticism to the market. Occasionally market participants can become over-zealous about a stock, leading the value to skyrocket beyond its realistic limits. 

Recently hedge fund short selling has become more common, making shorting stocks more acceptable in the public eye.

Who are short sellers?

In general, there are three categories of short sellers:

1. Individuals: Experienced investors who utilize short selling either to hedge risk on a long position or by speculating on the value of a stock falling. Speculators are using short selling to generate profit for themselves.
2. Hedge funds will hedge market risk by shorting in areas of the market they believe the price of a stock is overvalued. 
3. Hedgers: Investors will often use short selling to lessen their risk on a long position. 

Why is it beneficial to short sell?

If you missed the opportunity to invest early in a stock whose value increased significantly, shorting can be a way to earn a profit on that stock when the market price is high. Suppose you speculate the stock is overvalued or may drop in value in the future. In that case, you then have the chance to profit from the stock. 

You can also use the "shorting against a box" strategy by shorting shares that are in a trust and can't be liquidated. You can borrow shares from their trust and short sell them to gain profits within the trust rules.

What is the controversy of the short-sale rule?

The 2008 market crash closely followed the repeal of the short-sale rule in 2007, which led to significant scrutiny around the appeal of the short-sale rule and its effects on the market.

Is the short-sale rule effective?

There is no definitive consensus on the effectiveness of the short sale rule. However, it's still something that investors must be aware of and navigate when short selling. 

Can you short crypto?

Yes, it is possible to short sell cryptocurrency. There are numerous ways for investors to short crypto if they believe it is overvalued and due to crash. Investors can short crypto through margin trading or even through their own crypto assets. 

The bottom line

If done correctly, short selling stocks can quickly yield significant profits. Still, the strategy comes with substantial risks and regulations that you must take into consideration. Remember the alternative uptick rule: If a stock price drops by more than 10% in a single trading day, you cannot short said stock for that day and the following trading day.