How do I short thee? Let me count the ways…

There are various means of trading securities on their way down

Image by Les Bohlen from Pixabay.

All this chatter of the inverted yield curve and an impending nationwide recession has stirred many stock market bears who were still somehow hibernating out of their slumber. Currencies and stocks and entire indices are being picked apart and identified as candidates for shorting. Which begs the question: Once the due diligence has been done and the target security selected, what are the different (and most suitable) ways of actually going about it?


Short selling shares

Shorting a financial security means you intend to profit from a decrease in its value. The oldest and simplest form of this — and the most dangerous — has always been to borrow a company’s shares from a broker and sell them into the open market “on margin”. Ideally, from that point forward the stock moves down in price and, once your strategy has played out enough to your liking, you purchase the block of shares back at a lower price than what you initially sold them for. In so doing, you will effectively return the borrowed shares to the broker and pocket the difference between your original sale price and the price you reacquired them at.

Logistically-speaking, the actual mechanics of this procedure — the borrowing and returning of shares, for instance — are taken care of for you. What you do need to know is some terminology: “sell short” to initiate the trade, and “buy to cover” to close the trade out. Also, understand that there are restrictions around this type of transaction, such as that you can’t sell stock short in any type of IRA account. What’s more, the account you do use has to be approved for margin trading and have sufficient funds or other eligible securities in the account to cover at least some of the value of the stock you’ll be short-selling, if not all of it plus some percentage of that market dollar amount. This latter percentage chunk can be thought of as an extra security buffer in case your trade goes against you.

In other words, you may need as much as 150% or more of the value of what you are going to short — be it shares, electronically traded funds and notes (ETFs and ETNs), currencies (forex/fx), or what have you — in your account in cash or eligible liquid financial assets like other stocks. If the value of the security you’re shorting goes up in value instead of decreasing as you had hoped, and you attempt to ride it out thinking that the trade will eventually go in your favor, you may receive margin calls at certain points along the way. You can think of these as checkpoints, where your broker checks in and demands that you add more cash or securities to your account to cover your losing position, so that you don’t bring the house down with you. Your broker may even start selling other positions you have open in your account to bring you back in line with its margin requirements, and it is legitimately entitled to do so.

Remember, those shares have been lent to you, and the house needs reasonable assurances in the form of sufficient collateral that you’re good for it and that they’ll get those shares back eventually in order to return them to their rightful owner. While there are always transaction fees, you may additionally pay interest on the borrowing of the shares or any margin trading balance you maintain with your broker, so get to know your broker’s cost structure well. In specific cases, you will not pay any interest expenses to borrow shares and sell them short; it is best to inquire directly with your broker.

Otherwise, when you choose to sell some security short, be aware that the trend over time throughout the history of financial securities trading has been upward; i.e. the Dow Jones Industrial Average has continued to climb in nominal value over its multi-decade lifespan as a stock index, not shrink to zero. Publicly-traded companies are going concerns that tend to stay in business for rather long periods. It boggles the mind a bit, but IBM has been around in some form or fashion for 108 years (as of the publication of this piece), and it has been listed on the New York Stock Exchange (NYSE) that entire time. Approach your short trades accordingly; don’t think that you’re going to outlast every company you go after with an ongoing short position, somehow invariably riding it into the ground.

Similarly important is realizing that your losses are limitless, as the price range of any security is technically zero to infinity. The zero end of the spectrum represents the max profit you can obtain when shorting from the sale price you started at, while the infinity end is your max loss, since there’s nothing in place in the system to stop a security’s price from rising endlessly to a price of $1 gazillion or beyond. (As an aside, there is a way to protect yourself from this boundless downside, though: you can hedge such a short-sale position with call options).

Short-selling shares :: summary

Pros:

  • Can maintain the short position so long as you have sufficient resources to cover your broker’s margin maintenance requirements.
  • Can utilize the funds you received from the sale to pay for some other financial instrument that itself could earn you returns. This is the act of using leverage to expand your capacity to invest. You may incur additional expenses in the form of margin interest and other fees.
  • Can usually easily exit the position for whatever reason by reversing out of it: “buy to cover” the same number of shares of whatever company you shorted and you’re done.

Cons:

  • Must be approved for a margin account.
  • May have to pay interest on margin amounts.
  • Max loss is limitless.
  • There can be share availability issues preventing you from being able to borrow shares of a company to short in the first place; as in, your broker will literally not be able to provide you with borrowed shares to short, so you cannot enter into the transaction.
  • You are indirectly inviting your broker in to take action on your behalf should the trade go against you and it be deemed necessary to free up funds to cover your obligations arising from your trades.

Example:

You have sold short shares of Ford Motor Co. (F) because you anticipate that the other ratings agencies will follow suit and downgrade Ford’s outstanding debt before the company can make significant headway in resolving the numerous operating issues it faces. The downgrades will mean that Ford’s debt no longer meets the quality requirements for inclusion in certain investment-grade bond indices. With a worse credit rating, it will be more difficult and costlier for the company to raise funds and risk-averse investors will sell out of their Ford holdings, including the stock. You figure its better to short the shares than buy puts because you’re unsure of the timing. The stock isn’t incredibly volatile as things stand today, so you don’t expect the share price to move against you in a considerable way, but all the same you have hedged your position with call options to cap any losses. Ford shares are currently easy for your broker to borrow and provide you with for shorting purposes, so you do not pay any additional fees to sit on the position.

Selling Ford Motor Co short. Note the “Sell short” option highlighted in the action menu.

Derivatives: put options

Options, futures, forwards, and swaps are financial derivatives products (derivatives/FDs). They are derivatives because they derive their value from the metrics of other assets to which they are attached, referred to simply as the underlying. The latter may be a stock like Microsoft (MSFT), or an index like the S&P (SPY), or a fund that tracks the price of a particular commodity such as silver (SLV).

In the context of shorting a security, the obvious equivalent in the options world — which is the derivatives sphere that the average retail investor is most likely to personally encounter — is the put option. This instrument, the put, is really a contract with certain parameters, valid only for a predetermined span of time. At the end of that time span (or sooner), it can be fulfilled (exercised) if the conditions of the contract are met by that date. By the same token, it can be terminated early or left to expire worthless at the end of its lifespan if the conditions are never met.

These types of options contracts are purchased, or entered into, in much the same way that one would purchase equities, except that the language utilized can sometimes include “buy to open” and “sell to close”, not solely “buy” and “sell”. (That being said, for reasons we won’t get to here, you can also write your own options, or begin by selling them, not buying them; just FYI.)

Puts are predicated on the possibility that the underlying assets they are attached to go down in price past a certain threshold in the time allotted by the contract. If you believe Macy’s shares might lose a specific amount of value within some future period because the company will have a harder time than other retailers weathering competition, trade wars, a recession, and slumping interest in their brand, you can put your money where your mouth is and buy (go long) a put option that’s good for anywhere from a day to a week on up to two years or even longer. The option contract will be in effect for some period from the moment you buy it until its expiration date, which is stated upfront (expiration date), and there is a target price (strike/exercise price) that needs to be hit in order for the contract to be exercised and/or realize its full value potential.

The option chain for Macy’s is shown here. Puts expiring in January 2021 are on the right, calls on the left. Those options highlighted in yellow are “in the money”, meaning the underlying stock has exceeded the strike price. For puts, the current price of Macy’s stock is therefore below the strike price, whereas for calls, it is above. In addition to the bid/ask spread, one can view the last price a contract traded hands for; the volume for the day; and the open interest, or how many contracts are outstanding. Note the other expiration dates, including contracts expiring in 2020 as well as 2022.

If for instance the stipulations of the contract remain unmet once you enter into it, such as the underlying stock unfortunately doesn’t sink down toward the strike price as you thought it might but stays flat or even climbs, the time value of the put experiences decay instead. The value of the time allotted for the contract’s parameters to be met is frequently the bulk of its value, and time keeps slipping away, after all. One of the only sure things in this world is the passing of time, and these contracts do not age well if the circumstances aren’t favorable.

However, you’re not locked into your position. You can unwind your trade by “selling” or “selling to close” the put. Indeed, selling your put before it expires is often the goal if the trade is going favorably, that is if all you are doing is speculating on the price movements of a company’s stock. On the other hand, puts may be purchased to hedge open positions in the stock themselves; the contract allows you to unload your shares at that agreed upon strike price instead of a lower going market price, if that threshold has been met and you wish to exercise the contract and rid yourself of your shares. That’s a purpose of another kind — the insurance policy kind — and it speaks to the multi-function nature of options.

Shorting with put options :: summary

Pros:

  • These instruments are cheaper to purchase than inverse funds for the same amount of exposure (each contract represents 100 shares of the underlying).
  • The parameters, such as length of time the contract is in effect and the price at which it can be exercised, are clear cut.
  • Your max loss is known upfront, much like the amount you wager in a bet. It’s what you spend to buy the put. So long as you’re not buying it on margin, its cost plus brokerage transaction fees and commissions constitutes your total outlay.

Cons:

  • Must receive brokerage approval to trade options with margin approval wrapped up into it, as well (at least Tier 2 — standard margin). This usually involves questions regarding your income and investment intentions, among other things.
  • The option imposes a time limit on your trade going your way.
  • The investment can expire worthless. Along the way, its time value can continue to decay if the parameters of the put are not being realized or seem like they won’t be.
  • The contract will maintain value close to what you paid for it only so long as there remains a reasonable expectation that you will hit your strike price, either because there is still plenty of time left, or because the markets have been sufficiently volatile, or because the underlying continues to hover around the strike price (it is near the money).
  • Contract pricing can be impacted by market sentiment. For many securities right now, puts are more expensive than calls and are selling at a premium, indicating that market sentiment is bearish.
  • With some underlying securities that are not as heavily traded, for example, you may find that the range of contracts is limited. Perhaps you won’t have as much choice of contract lengths, for one.
  • Some securities have no associated options contracts available. The closed-end fund, Pimco Income Strategy Fund II (PFN), is one such example.

Example:

Over a year ago, you purchased LEAPS puts (long-expiry options contracts) expiring in January 2020 with an “out of the money” strike price of $7.50 on the retailer Bed Bath & Beyond (BBBY). You anticipated that their share price would fall further from where it was as they struggled to compete for the American consumer’s attention with the likes of Amazon.com. Their stock did indeed keep sinking, at one time even sliding past your exercise price with plenty of time left in the contracts. Instead of holding the puts for longer in the hopes of yet more unrealized gains, you decided to capitalize on your intuition; you sold them for a profit, which consisted in part of the time value still left, and in part of the reality that the strike price had been reached and the options could be exercised.


Inverse (and leveraged) ETFs, ETNs, and index funds

Some funds out there are geared towards shorting indices, sectors, and other market components. The managers of these funds normally use derivatives to accomplish this. Take the ProShares Short S&P500 ETF (SH),

which seeks daily investment results, before fees and expenses, that correspond to the inverse (-1x) of the daily performance of the S&P 500®. ~ProShares

The ETF takes a one-for-one contrary position to the performance of the S&P index. You can invest in it the exact same way you invest in plain vanilla equities, by buying and selling shares at the going price, except you do so because you are banking on market corrections, declines, recessions, or crashes, and so on (or you are hedging your existing stock portfolio). In the case of SH, when the S&P has a bad day, the fund has a good one.

The ProShares Short S&P500 inverse fund (SH), courtesy of Morningstar.

Shorting with inverse funds :: summary

Pros:

  • You can hold your position for as long as the fund continues to exist. You do not need a margin account to trade such a security. Hence, as long as you don’t buy the shares on margin, your total cost and max loss are limited to what you spend on the shares themselves, plus applicable brokerage fees and commissions.

Cons:

  • Inverse funds can experience reverse splits, especially as the historical price trend for investments is upward. These events can slowly dissolve the value of your position over time. They are especially likely for funds that are twice or three times leveraged, or for incredibly volatile industries or sectors. For example, I’ve personally experienced reverse splits as the holder of a Canadian fund that was designed to return twice the inverse of an index of junior gold miners. In other words, it was meant to reflect 2x the price changes of the daily movements of that collective group of mining stocks, going up when the miners had a down day, and going down when they rose.
  • They tend to be more expensive to buy into than options for the same amount of exposure. There is an opportunity cost, therefore, as this uses up more of your resources which could be employed elsewhere on other trades.

Example:

You have bought into Deutsche Bank’s Gold Double Short ETN (DZZ), an electronically traded note which seeks twice the inverse of the Deutsche Bank Liquid Commodity Index-Optimum Yield Gold. In essence, it is designed to reflect changes in the price of futures contracts in gold, moving up when the price of gold sinks (but falling when gold rises). You anticipate using the instrument to capitalize on possible near-term drops in the price of gold. Your potential returns (losses) will be enhanced by the leveraged nature of the investment vehicle.


Options on inverse (and leveraged) ETFs, ETNs, and index funds

This is a stack play. Take the inverse fund SH, mentioned above. Instead of merely buying into SH expecting the S&P to decline, you can buy a call option on SH (essentially a derivative on a derivative) with the same idea in mind. A call is a contract predicated on the possibility of the underlying going up in price. Thus, what you’re really doing here is buying an instrument designed to go up in price when the underlying goes up in price when the underlying of that goes down in price, savvy? The flip side of this is buying a put option on a fund that is designed to go up in value when its underlying goes up in value.

Shorting with options on inverse funds :: summary

Pros:

  • The same as those for put options mentioned earlier, plus…
  • Cost savings: it’s a less expensive alternative to buying shares in an inverse fund.

Cons:

  • The same as those for put options mentioned earlier.

Example:

You buy inexpensive call options expiring six to nine months out on SH “near the money” in order to hedge your long positions in equities at a lower cost than buying shares in the ETF itself. In this way, the call options are serving the purpose of cheap insurance contracts, protecting you somewhat against broad stock market declines by mitigating any unrealized losses you may experience, since they will gain value if the S&P corrects.


Final thoughts

The list presented above is not exhaustive. There are “synthetic” ways of creating a short position, which is to say that there are ways of stringing together derivatives and securities to synthesize a short position in the target security.

Also, take note that you can’t short a single company through an inverse ETF (but you can short a representation of an industry index that that corporation belongs to), and you can’t technically sell short an actual sector or index mutual fund; you have to use an ETF/ETN (or option on an ETF/ETN), which is typically part derivatives.

The most flexible means of shorting a security is via a put option. This flexibility may help explain why options have grown to be so popular.

HedgeHound

Hedge…everything.

Philip Valenta, MSF :: [mezcalindo]

Written by

Intersectionist.

HedgeHound

Hedge…everything.

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