What is short-selling?

Many traders focus only on buying stocks, which is also referred to as “buying long,” because the shares are said to be held “long” in their account. In this scenario, the goal is to buy low and sell high.

Short-selling is the same concept, but with the sequence reversed. Traders identify a stock that they think may decline. Then they borrow the stock from their brokerage firm and sell it with the expectation of buying it back later at a lower price and thereby realizing a profit.

The mechanics of short-selling.

In order to sell a stock short, a trader must be able to borrow shares of that stock from their brokerage firm to deliver to the buyer of those shares. As a result, short-selling can only take place in a taxable, margin-enabled account. Short-selling may not take place in retirement accounts, because IRS regulations prohibit margin-borrowing agreements in those accounts.

The risks of short-selling.

It’s important to understand the risks of short-selling. The most obvious risk is that instead of declining, the stock might rise, forcing the trader to buy it back at a higher price than when the short sale was initiated—resulting in a loss of capital. On the surface, this seems no different than buying the stock with the expectation it will rise in value, only to see it decline instead. However, with short-selling there’s a catch.

If you buy long and the stock declines to zero, the most you can lose is 100% of your investment. If you short a stock, the stock price can theoretically rise an unlimited amount, potentially resulting in more than a 100% loss. This is the first of several reasons why short-selling may be considered more difficult than buying long.

Consider the not-so-obvious risks of short-selling. The first is that shares may be unavailable to borrow in order to sell short, and the trader may not be able to initiate a short sale. In this case, shares are said to be “hard to borrow.”

Another not-so-obvious risk is that once shares have been borrowed and a short sale has been initiated, a trader can receive a “forced buy-in.” This means that the original owner of the shares borrowed through the margin account wishes to sell them, and no other shares are available to lend. The trader who shorted the borrowed shares is then forced to buy those shares back and cover their short position so that the original owner is not inconvenienced. The short seller has no control over this event, which may occur at any time.

Additionally, if the stock pays a dividend, the short seller is responsible for paying the dividend, which adds to the cost of a short sale and reduces the potential return.

Tax implications of short sales.

A unique characteristic of a short-sale transaction is that the closing date for the short sale uses the settlement date of the cover order. IRS regulations require brokers to report the closing transaction on short positions based on the settlement date of the shares that were bought to cover the short sale, not the trade date. For example, if you are covering a short position in 2016 for 2016 tax reporting, then you need to ensure the shares bought to cover settle in 2016. Your broker issues you a Form 1099-B showing the stock was sold using the purchase dates and the sale dates from the settlement date for the buy cover that closed the short sale.

Another unique feature of a short sale is that any dividends that were paid may be tax-deductible. We recommend that you consult your tax advisor for details on the tax implications and handling of short-selling.

The bottom line.

Short-selling stocks can be a way to profit in declining markets, but it’s important to understand the risks.

Additional resources.

Learn more about short-selling stocks.

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