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4 Rules for Short Selling

Day trading has become more popular among stay-at-home workers, and one strategy to make money is to short sell.

Luke Babich //February 15, 2022//

4 Rules for Short Selling

Day trading has become more popular among stay-at-home workers, and one strategy to make money is to short sell.

Luke Babich //February 15, 2022//

WHAT IS SHORT SELLING?

Short selling generally entails betting against a stock’s decline. It can yield big rewards, but it’s a complicated and risky venture.

Essentially, you sell a high-priced stock that you’ve borrowed from another investor and wait for the price to decline. Then, you buy more shares at a lower rate and return them to the lender, pocketing the difference in price.

Talk to a financial expert about the best ways to invest your money and if short selling is a good bet for you.

For example:

Stock in a bagged salad company is flying high. As a smart investor, you’ve borrowed 100 shares worth $40 each from another investor and sold them for a total of $4,000 before what looks to be a severe winter, when salad sales typically decline. When a listeria outbreak strikes, salad stock plummets to $25, and you buy 100 shares for $2,500. You then return them to the lender and realize a $1,500 profit.

Investors turn to short selling when it appears they’ve missed an initial opportunity to capitalize on a stock’s success. By speculating on its eventual decline, it’s possible for investors to still make a substantial profit.

POTENTIAL PITFALLS

The biggest risk of short selling is that the stock you’ve borrowed remains high and you aren’t able to buy at a lower price. Some investors look for potential short sales among high-dividend stocks, only to owe thousands of dollars when they continue to perform well.

Consider also:

  • You may have to pay brokerage fees
  • You may need to pay dividends on the borrowed stock

Short selling is not a good choice for people who are just learning to invest or need more security for their money. The risks are high, and it requires near-perfect timing and discipline to get it right.

RULES FOR SHORT SELLING

Professional and amateur investors must follow these four short-sale rules.

1. You Need Permission

Before short selling, you’ll need to access margin trading, which requires permission. A brokerage can help you set up a margin account.

2. Fund Your Margin Account

Margin accounts need to be funded at 150 percent, which means you’ll need to add 50 percent of your potential stock proceeds. If you have 100 shares selling at $10 per share, you’ll need to add $500 to your account.

3. Pay Interest

There are fees associated with borrowing stocks, and you’ll need to pay interest to the broker or brokerage from which stocks are acquired.

4. You Can’t Buy When Stock Trends Down

The only time you can place a short sale order is when stock is stable or rising. When a stock price drops, short sales are not allowed.

SHORT-SALE RESTRICTIONS

No Naked Short Sales

Naked short selling involves selling shares that have not been borrowed or that may not exist. This rule arose during the 2008 financial crisis when panicked bankers and investors attempted to mitigate their losses.

Follow the Uptick Rule

Also referred to as a short-sale restriction, or SSR, the Securities and Exchange Commission restricts the short sale of stocks that have declined 10 percent or more in one day. Once the rule is triggered, it remains in place until the following day.

Holding Stocks in Two Positions isn’t Allowed

Investors can’t hold the stocks of a company in a short (borrowed) and long (owned) position at the same time. Doing so means they’re betting that the stock will crash (short) and soar (long) simultaneously.

Short Sales Must Be Reported

The Short Sale Transparency and Market Fairness Act was introduced in 2021 as an amendment to the Securities Exchange Act of 1934. The bill requires large companies to report short sales within 10 days of the month’s end. Individual investors who place short sales through brokerage accounts must also report their sales.

Short Selling Real Estate

Short selling real estate follows many of the same rules as short selling stocks. Discount real estate brokers can perform a comparative market analysis to help investors find distressed properties that are listed for sale below market value, potentially because of a homeowner’s inability to pay and desire to avoid foreclosure. Investors buy the properties, make necessary repairs, and then sell at market price.

If a homeowner can prove hardship, and an appraisal shows a home is worth less than the mortgage balance, a lender may approve the short sale. A short sale is designed to quickly liquidate the bank’s holding and prevent further loss.

Buying and selling investment properties can result in a large profit, but also a large tax bill. You can save money using a 1031 exchange that allows you to defer your capital gains tax.

 

Screen Shot 2021 12 28 At 113128 AmLuke Babich is the Co-Founder of Clever Real Estate, a real estate education platform committed to helping home buyers, sellers and investors make smarter financial decisions. Luke is a licensed real estate agent in the State of Missouri and his research and insights have been featured on BiggerPockets, Inman, the LA Times, and more.