9 Frequently Asked Questions About Short Selling
Short-selling, or “shorting a stock,” is an advanced trading strategy that involves potentially unlimited risks. But traders who know what to look for can still use it to their advantage. Here, we’ll take a look at the basics of short selling, when you might consider it and nine frequently asked questions.
- What is short selling?
- What does it mean if a stock is hard-to-borrow (HTB)?
- How does a short sale work?
- What happens if dividends are paid on borrowed shares?
- What happens if the lender wants to sell the shares that have been borrowed?
- How do you know if there are shares available to borrow at Schwab?
- When do you have to buy the shares back?
- What are the margin requirements?
- How can you try to manage risk on a short sale?
2. What is short selling?
Short selling is the sale of borrowed stock. Generally, traders sell short when they expect a stock’s price to decline. This is also called a “directional short.” People also sell short to facilitate hedging and arbitrage, but we’ll focus on directional shorts.
To start a short sale, you must have a margin account with a brokerage firm, which allows you to borrow stocks from either Schwab’s own inventory or from an outside custodian bank or broker-dealer, using your own eligible securities as collateral. Then, you sell the borrowed security, which leaves a negative share balance that is then maintained in your margin account as a "short position." To close the short position, you must buy back the security. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. However, if the price of the stock rises, you might have to buy back the security at a higher price for a loss.
Here are two examples of how profit or loss is calculated on a directional short sale. (Trade commissions, margin interest, and fees are not included in these calculations, but can affect final outcomes and should be considered.)
- Short 100 shares XYZ @ $20, total proceeds = $2,000
- Stock price drops to $15, client buys back the 100 shares XYZ @ $15, total cost $1,500
- Total profit = $2,000 - $1,500 = $500
The maximum loss on a short is unlimited: The short seller's losses accumulate as the price goes up, and the stock price could theoretically increase infinitely.
- Short 100 shares of XYZ at $20: total proceeds = $2,000
- Stock price increases and remains at $30 until expiration date
- Client buys back the 100 shares of XYZ at $30: total cost = $3,000
- Total loss: $2,000 - $3,000 = -$1000
2. What does it mean if a stock is hard-to-borrow (HTB)?
- Easy-to-borrow (ETB) means that there’s a supply of a stock and generally would be available for short selling.
- Hard-to-borrow (HTB) means that there’s limited supply of a stock for short selling. In this case, you’ll have to pay a daily stock borrow fee, which changes based on a stock’s price and its availability.
3. How does a short sale work?
Let's take a look at how a short sale of an ETB stock might work, keeping in mind that the borrowed stocks are made available from other Schwab customers or from outside sources.
Short selling in practice - Source: Schwab Center for Financial Research. These examples are hypothetical and do not account for dividend and interest payments, taxes, trade commissions or other fees or expenses that could reduce returns or increase losses.
- Long holder, Mr. Armstrong, believes the XYZ stock will increase over time and buys 300 shares of XYZ in his margin account. He receives a dividend payment on the stock.
- Short seller, Ms. Bourne believes the price of XYZ stock will soon decrease and enters an order to sell short 100 shares XYZ.
- Schwab borrows the 100 shares from Mr. Armstrong to lend to Ms. Bourne to sell.
- When the short sale is executed, Mr. Armstrong’s account and positions remain unchanged, but Ms. Bourne’s account will show a short position (-100 shares XYZ).
4. What happens if dividends are paid on borrowed shares?
Now, let’s assume that a dividend is paid on XYZ while the shares are being borrowed. Schwab will typically allocate a substitute dividend payment to the lender, Mr. Armstrong, in lieu of the dividend, and will debit the substitute dividend payment amount from the borrower, Ms. Bourne. The payment in lieu of the dividend may not be entitled to the same tax treatment as may have been applied to the receipt of the actual dividend.
However, Schwab typically makes efforts to compensate lenders for any differential tax treatment. Schwab clients may refer to their Schwab Account Agreement for more information on payments in lieu of dividends.
5. What happens if the lender wants to sell the shares that have been borrowed?
Next, let’s assume Mr. Armstrong wants to sell all 300 shares of XYZ.
- Mr. Armstrong simply places the sell order for 300 XYZ as usual. He is free to do this as he is the rightful owner of the shares.
- If there are additional shares available for shorting, Ms. Bourne may continue holding her short position using those additional shares. If these shares are ETB, Ms. Bourne would continue to short without any additional fees. However, if the shares are HTB, she would pay a fee to continue to borrow the shares.
- If the sale results in unavailable shares, Ms. Bourne's short position will be closed out via a purchase at the current market price by Schwab, at Ms. Bourne's expense, and potentially without notice. This enables proper delivery of the shares to Mr. Armstrong.
6. How do you know if there are shares available to borrow at Schwab?
When you are placing an order on Schwab.com, you will see a note on the order entry verification screen if the security is hard-to-borrow.
Source: All-In-One Trade Ticket, Schwab.com
StreetSmart Edge® has a HTB indicator to let clients know that shares of a security are HTB for shorting. However, the absence of the indicator for a particular security does not guarantee that it will be available to sell short. If you have further questions about the availability of a particular security to sell short, please contact a Schwab representative.
In StreetSmart Edge®, the indicator appears in the top right of the All in One Trade Tool.
1. Open StreetSmart Edge.
2. Click Launch Tools.
3. Select All in One Trade Tool.
Source: StreetSmart Edge®
4. Click the Stock/ETF tab.
5. Navigate to the top-right of the stock trade ticket.
You will see the words “Hard to Borrow.”
HTB indicator in StreetSmart Edge
Source: All in One Trade Tool, StreetSmart Edge.
For more information on securing shares to borrow, clients can contact the Securities Lending Department at 800-355-2448.
7. When do you have to buy the shares back?
There are no regulations that limit the amount of time a short position can stay open; however, the following conditions may cause a short position to be closed out (bought back):
- Shares are no longer available to borrow: When a client borrows shares to short sell, the margin lender retains the right to recall the securities at any time and without notice. If the shares are recalled by the margin lender, Schwab will try to re-borrow the securities on the client's behalf. However, if shares cannot be obtained, Schwab is then forced to close out (buy back) the short position at the current market price, at the borrowing client's expense, and potentially without notice.
- There is an existing margin call on the account: Just as ‘long positions’ in accounts with margin calls are subject to liquidation at the discretion of the Margin Department (the department in a brokerage firm that monitors customers' margin accounts), a short position is also subject to possible closure when a margin call exists.
8. What are the margin requirements?
Short selling is subject to the initial minimum $2,000 account equity requirement for using margin, which is an account-level requirement. See Schwab's initial and margin maintenance requirements on short sales.
Schwab's initial and margin maintenance requirements on short sales
|Security price||Schwab initial requirements (prior to settlement)||Schwab maintenance requirements
(subsequent to settlement)
|> $16.67 per share||50% of proceeds||30% of market value|
|$5 - $16.67 per share||50% of proceeds||$5 per share|
|$2.50 - $4.99 per share||50% of proceeds||100% of market value|
|< $2.50 per share||50% of proceeds||$2.50 per share|
Source: Charles Schwab & Co., Inc.
Here’s a basic example of an initial margin requirement: If you sold short 1000 shares of XYZ stock at $20, for a value of $20,000, you would need to have $10,000 in your margin account—that is, 50% of the value.
- Number of shares: 1000
- Price: $20
- Value: $20,000
- Margin %: 50%
- Requirement: $10,000
It's important to note that this table is just a guideline. The above figures assume a margin equity requirement of 30%; however, if the margin maintenance requirement on a stock is higher, then the maintenance requirement on the short will be higher. It's also important to note that these requirements can change at any time and without prior notice from Schwab.
9. How can you try to manage risk on a short sale?
The potentially unlimited loss associated with a short sale makes it important to proactively manage the risk.
A buy stop order can help manage loss on a short sale, in case the stock price goes up.
For a short sale, buy-stop orders trigger a market order to buy back when the stock trades at, or above, the designated stop price.
An alternative order to consider is the trailing buy-stop. With this order, the trader can specify a percentage or dollar amount from the securities low trade price to cover their short trade. If the ask price only moves upward (against you), the trailing stop will track the ask price until it reaches or surpasses your entered trailing amount. However, unlike the standard buy-stop order, when the price moves downward (in your favor), a trailing buy-stop will readjust the trigger price from the new low trade price.
Once you submit a trailing buy-stop order, it remains in force until it’s triggered by a specific price change in the inside ask price. Once triggered, it becomes a market order that’s submitted for immediate execution; however, there’s no guarantee that you’ll get any specific execution price or price range. The resulting execution price may be above, at, or below the trailing stop’s trigger price itself.
Let's take a look at an example of how these order types can help to control loss on a short sale.
Example: (Trade commissions and fees are not included in these calculations.)
Mr. Armstrong shorts 100 shares of XYZ stock at $30. Initially, the stock price moves down to $27, but then builds back up and ends the day at $33.
- If Mr. Armstrong had no exit strategy on his trade and closed the position at the end of the day, he would end the day with a loss of $3 per share ($300).
- If Mr. Armstrong had set a buy-stop on this order for $32 ($2 above sale price), the stop would have triggered when it traded at $32, and the Mr. Armstrong would incur a loss of approximately $2 per share ($200) assuming the order was filled at $32.
- If Mr. Armstrong had set a trailing buy-stop on this order for $2, the initial trigger would take place at $32. However, as the price moved downward, the trailing stop would have readjusted with each new low, settling to $2 above $27, or $29.
- As the price changed directions, the trailing buy-stop would have tracked the upward movement until $29, at which point the market order to buy would have triggered, resulting in approximately a $1 per share ($100) gain for Mr. Armstrong.
Keep in mind that there is no guarantee that a stop order will execute at or near the stop price.