How to Short Stocks?

If you're "short" on an asset or security, it means you're positioned to profit from a drop in its price. The opposite of being short is being "long," where you benefit from an increase in the price of a security. Shorting a stock reflects a belief that its price will decline. Short-selling involves selling assets or securities that you don't currently own, with the intention of buying them back at a lower price later.

When you borrow and short-sell an asset, whether it's a precious metal, stock, or bond, you become physically short of that asset. This process opens a short position. Later, when you buy back the asset and return it to the original owner, you close your short position. In a short trade, the sequence of actions is the reverse of a typical long trade, where you first buy the security and later sell it.

Shorting a stock is a strategy with inherent risks, one of which is the obligation to compensate the stock lender for any dividends paid during the short position. While a security’s price can only drop to zero, theoretically, there is no upper limit to how high it can rise. This creates an asymmetry in risk: in a long trade, your potential loss is capped at the cost of the security, while your potential gain is unlimited. Conversely, in a short trade, your potential profit is limited to the initial stock price minus trading and borrowing fees, but your potential loss is unlimited, as the stock price can keep rising.

Given this risk profile, shorting stocks is generally unfavourable, with the odds stacked against you. You should consider shorting a stock only if you have a strong conviction that the stock’s value will decline significantly in the short term. As a retail investor, you would rely on your broker to facilitate borrowing the stock for shorting. Your role is simply to place a sell order.

When you sell a stock you don’t own, your broker automatically recognizes it as a short sale. The broker should only execute your sell order if they are reasonably confident they can deliver the security for settlement within two business days. If other customers have those stocks in a margin account, the broker can lend them to you for the short sale.

A margin account allows a customer's assets to be used as collateral, enabling them to borrow money or securities from their broker. All customer assets are registered under the broker's name, with retail customers as beneficial owners. This means that while they legally own their securities, these are not registered in their name.

If a broker wishes to lend securities from a customer’s cash account, they must obtain permission, as the broker holds those securities for safekeeping (in trust). However, in the case of margin accounts, the securities are held as collateral, giving the broker the right to lend them out without seeking additional consent. Just as borrowing money from a broker or financial institution incurs interest, borrowing securities comes with a borrowing fee or stock loan fee, typically expressed as a percentage of the security's price.

Large institutions like pension funds, mutual fund managers, ETF sponsors, and similar entities often lend their shares to generate additional income. Brokers typically approach these holders when their larger clients need to borrow a stock. The borrowing fee is determined by supply and demand and can fluctuate daily based on how easy or difficult it is to locate the stock. While borrowing fees are usually small compared to stock price movements, in cases where many investors are shorting a stock and few lenders are available, borrowing fees can exceed 60% per year.

It might seem logical to short a company with accounting irregularities, as such issues can signal a potential decline in stock price. However, when regulators become aware of these irregularities, they may halt trading in the stock for extended periods. In such situations, short sellers are forced to continue paying borrowing fees even while the stock price remains frozen, potentially leading to significant costs.

Just as borrowing money to buy stocks requires collateral, borrowing shares to short them also requires collateral. The amount of collateral needed depends on the specific stock and your broker's policies, but it is always more than the stock's current price. The proceeds from the short sale provide part of this collateral, while the remainder must be supplied by you, either in cash or in marginable securities. Marginable securities are those that can be purchased on margin.

After selling a stock short, if the stock price decreases, the collateral required for your short position decreases, increasing your account’s excess margin. Conversely, if the stock price rises, the required collateral increases, reducing your account’s excess margin. If the price movement is significant enough to push your account into a margin deficit, you will receive a margin call.

A margin call is when your broker demands that you deposit additional funds into your margin account. If you are unable to do so quickly, the broker may buy back the shorted stock to close your position. Some brokers, like Interactive Brokers, may not give you time to add funds and might close your position immediately if a margin deficit occurs.

A similar situation can occur in a long trade if you have purchased stocks on margin and their price drops. Anytime you use leverage—whether buying with borrowed money or selling borrowed securities—you risk being forced out of your position. You might be correct in your assessment that a shorted stock is overvalued or a stock bought on margin is undervalued, but you could still be forced to close your position prematurely, potentially incurring significant losses.

John Maynard Keynes, the renowned British economist, was a successful investor until he lost much of his wealth in the 1929 stock market crash. He famously said, 'The market can stay irrational longer than you can stay solvent.'

The Investment Industry Regulatory Organization of Canada (IIROC) regulates brokers, dealers and exchanges in Canada. IIROC, twice each month, publishes a short sale trading statistics report and a consolidated short position report. The first report informs the public about the portion of each securities trade being short sales. In comparison, the second report informs the public of the aggregate number of short positions in each security.

According to the most recent report by IIROC, the security most shorted in Canadian markets is the TORONTO-DOMINION BANK, with close to 51 million shares sold short. This large position is because short sellers are expecting the US government to impose large penalties on TD as it has failed to stop some money being laundered through its US operations.

The second and third most shorted securities on Canadian markets are Telus Corporation, with the ticker symbol T and TC ENERGY, with the ticker symbol TRP.

25 Most Shorted Canadian Securities (Stocks) as of August 15, 2024
Security Issue Name	Security Symbol	No.Shares
TORONTO-DOMINION BANK (THE)	TD	50,776,258
TELUS CORPORATION	T	47,689,833
TC ENERGY CORPORATION	TRP	44,264,685
MANULIFE FINANCIAL CORPORATION	MFC	41,149,362
ATHABASCA OIL CORPORATION J	ATH	39,750,145
ENBRIDGE INC.	ENB	37,381,061
BANK OF NOVA SCOTIA (THE)	BNS	36,255,039
ISHARES S&P/TSX 60 INDEX ETF UNITS	XIU	31,180,071
CANADIAN IMPERIAL BANK OF COMMERCE	CM	31,027,003
CANADIAN NATURAL RESOURCES LIMITED	CNQ	29,063,227
ALGONQUIN POWER & UTILITIES CORP.	AQN	22,309,753
PEMBINA PIPELINE CORPORATION	PPL	20,175,479
BCE INC.	BCE	20,101,570
BAYTEX ENERGY CORP.	BTE	18,094,622
FISSION URANIUM CORP. J	FCU	16,338,650
BIRCHCLIFF ENERGY LTD.	BIR	15,821,433
NORTHWEST HEALTHCARE PROPERTIES REIT UN	NWH.UN	15,760,522
SUNCOR ENERGY INC.	SU	15,755,998
SUN LIFE FINANCIAL INC.	SLF	14,476,043
ROYAL BANK OF CANADA	RY	14,053,757
LUNDIN MINING CORPORATION	LUN	13,742,991
POWER CORPORATION OF CANADA SV	POW	13,189,540
SHOPIFY INC. CL 'A' SV	SHOP	12,924,055
BLACKBERRY LIMITED	BB	12,734,250

Considering short positions taken by other investors is essential for gauging sentiment as well as assessing risk. On the one hand, it is an indicator of sentiment in the market. On the other hand, seeing a significant short interest tells anyone who wants to take a long position that there is likely a compelling case to be made against the stock, and they are better off thinking through their reasoning for going long.

Over the first half of August 2024, 3iQ Ether Staking ETF (ETHQ.U) has the highest portion of short-sale trades, followed by Great West Life (GWO). ETHQ is a fund holding and staking Ethereum (a cryptocurrency), and GWO is a large insurer specialized in health insurance.

Canadian Securities with the Largest Portion of Trade Value Being Short Sale as of 15 August 2024
Security	Company Name	Listing Market	Short Sale Trades	% Total Trades	Short Traded Volume	% Total Traded Volume	Short Traded Value
ETHQ.U	3IQ ETHER STAKING ETF UNITS USF	TSX	15	12	1,752,765	99	$21,525,268
GWO	GREAT-WEST LIFECO INC.	TSX	28,913	32	30,483,283	68	$1,260,159,041
RMB	Rumbu Holdings Ltd.	TSXV	4	11	155,000	58	$38,750
BNRE	BROOKFIELD REINSURANCE LTD. EXCHANGEABLE A LV	TSX	1,942	49	241,133	57	$14,788,613
ALA.PR.B	ALTAGAS LTD. FLTG RATE SERIES 'B' PR	TSX	43	40	13,900	56	$288,985
SU	SUNCOR ENERGY INC.	TSX	97,073	30	58,854,015	55	$3,161,194,459
ERO	ERO COPPER CORP. J	TSX	19,396	55	2,517,250	54	$65,410,074
IFC.PR.K	INTACT FINANCIAL CORPORATION CL A SERIES 11	TSX	50	49	16,300	54	$370,348
NG	NOVAGOLD RESOURCES INC. J	TSX	11,688	48	2,354,767	52	$14,126,802
EFR	ENERGY FUELS INC. J	TSX	21,604	59	3,861,356	52	$25,217,084
FTS	FORTIS INC.	TSX	49,430	36	15,232,287	52	$897,333,819
DND	DYE & DURHAM LIMITED J	TSX	4,419	53	677,810	52	$8,671,053

Investor A shorted 100 shares of the Toronto-Dominion Bank on 16 May 2022 for $92 per share. They bought back these shares on 30 June 2022 for $84 per share. Investor A paid a $10 commission for each trade and an average 5% stock loan fee. After closing their position, Investor A felt they had left too much money on the table and decided to repeat their success. So they sold 100 TD shares on 4 July 2022 for $83 and repurchased those shares on 11 August 2022 for $85. The tally for these speculations is in the table below.

	First Speculation	Second Speculation
Proceeds of Short Sale	$9,200	$8,300
Buyback cost	$8,400	$8,500
Trade cost	$108	$104
Profit/Loss	$692	-$304

To answer this question, it is tough to investigate 1500 companies listed on Toronto Stock Exchange. So we consider the S&P TSX index as an average of Canadian listed companies.

Over the five years between mid 2017 and mid 2022, comparing each business day closing price to the last business day closing price, the index rose 706 days and fell 548 days. In other words, you would have done better on 56% of days being long, while you would have been better off short on 44%. But this comparison is unfair because the S&P TSX index comprises 250 of the most successful companies in Canada. Toronto stock exchange is constantly listing successful growing companies while delisting failing companies. Among these listed companies, more successful ones become members of the index while the weaker ones are left outside the index.

Inverse ETF

There are ways to benefit from a price decline other than establishing a physical short position. The easiest way to benefit from a price decline is to buy an inverse ETF. With an inverse ETF, you do not need a margin account and limit your downside risk.

Options

Another option for benefiting from a price decline is using options. There are two types of options: call options and put options. A call option gives you the right but not the obligation to buy an asset at a specified price called the strike price by a selected date called the expiration date.

Similarly, a put option gives you the right but not the obligation to sell an asset at the strike price by the expiration date. Buying put options would benefit you from a falling price; similarly, selling a call option would allow you to benefit from a falling price.

A synthetic short position can be made by buying at the money put and selling at the money call option. An option with a strike price very close to the current market price of the underlying asset (security) is called at the money (ATM).

Future Contracts

As the name suggests, a futures contract is an obligation by a seller to deliver an asset with specified quality and quantity at a specified date in exchange for a specified price. At the same time, the buyer must receive the asset with specified quality and quantity and pay the specified price for it.

Futures contracts are commonly used for commodities, precious metals and financial instruments. Commodities with active futures contracts include crude oil, natural gas, wheat, corn, copper, and aluminum. Selling a futures contract results in a short position, while buying a futures contract results in a long position. The margin requirement for futures contracts is typically 3%-12% of the contract's notional value. So when trading futures contracts, you leverage your deposit between 8 to 30 times. A multiple between 8 and 30 will amplify any profit or loss. This shows the grave risk involved in trading futures contracts for speculation.

Shorting can be done either for speculation on falling prices or hedging purposes. Hedging is any action that reduces the risk from a specific factor. For example, if you sell put options on RY, you face the risk of losing money if the price of RY falls. You can hedge this risk by shorting RY.

An airline sells plane tickets months in advance; it risks losing money if jet fuel prices rise. It can hedge this risk by buying (taking a long position in) futures contracts for jet fuel. A wheat farmer faces the risk of losing money if wheat prices fall significantly by the harvest time. They can hedge this risk by selling (taking a short position in) futures contracts for wheat. An activist investor buys a stake in a company and pressures the company to implement changes which would result in an improved share price. They risk losing money if the market as a whole decline, even if their strategy is successfully implemented. They might choose to hedge this risk by shorting a market index.

If you order various investment strategies based on their risk profile, you would have savings accounts and GIC investments on the low-risk end of the spectrum and short selling on the high-risk end of the spectrum while buying stocks would be in between. Some of the risks associated with short-selling stocks are explained below.

1. If you make a mistake, there is no limit to losses. For this reason, some traders use stop-loss orders on their short positions. These orders instruct the broker to buy back the stock if its price exceeds the loss they are willing to absorb.
2. There is no limit to the borrowing fee if the stock becomes hard to borrow. Also if the investor who has lent his shares wants to sell them and your broker cannot find other shares to borrow for you, you would have to buy back and close your position.
3. A short squeeze. If a stock is heavily shorted, it can become dangerous for short sellers. A rise in the stock price can trigger stop loss orders, which can cause a further rise in the stock price. This price rise may cause brokers to issue margin calls for other short sellers, potentially forcing them to repurchase the stock. So when a stock is heavily shorted, a danger exists for a self-feeding loop of price rises which might wipe out many short seller portfolios. When short interest in a stock is high, some traders might buy that stock to trigger a short squeeze and sell their shares to short sellers for a fast profit. To see what might happen in a short squeeze, consider the Volkswagen short squeeze in October-November 2008.

Two metrics, short interest and days to cover ratio, are often considered to gauge the sentiment about a stock and assess the risk of a short-squeeze. These metrics are defined as

and

Further, both of these metrics are related to the likelihood of a short squeeze.

Short sales can only be achieved in a margin account as there cannot be any borrowing nor leverage in a cash account. Thus, a physical short trade cannot be made under a tax shelter like a TFSA or an RRSP. Profit realized when you buy back the borrowed shares at a lower price is a capital gain and taxed as capital gains.

Being short is a term specifically used in relation to a fungible asset. Fungible assets are interchangeable, meaning one unit is the same as another. For instance, when you own a share in a company like the Royal Bank of Canada (RY), it doesn't matter which specific share you own among the 1.4 billion outstanding shares—they are all equal.

Likewise, the Canadian dollar is fungible, so any $50 bill and various combinations of other bills and coins totalling $50 are considered identical. In the case of pure gold, every ounce is indistinguishable from another, regardless of its source or the miner who extracted it.