Shorting can be an extremely successful strategy, especially in bear markets.
But is it possible to short in financial instruments other than stocks, or more specifically can you short ETFs?
What are the ways to do this, and what are the risks involved? We deep-dived these questions, and here is what we found.
About ETFs
Exchange-traded funds (ETFs) are financial instruments that pool investor money to track a particular index, group of securities, commodities, or any other asset class.
In principle, ETFs are very similar to mutual funds.
One major difference is that the latter can only be bought or sold at a single price point during the day.
ETFs, on the other hand, are traded very much like stocks. Their price changes every second.
Moreover, they usually have much lower expense ratios and commissions.
This is because most ETFs are passively managed and simply track indexes instead of a customized set of securities.
What Is Shorting?
Shorting is an investment strategy where a trader borrows shares from a broker to sell them in the market.
The objective is to buy it back later at a lower price, thus making a profit and squaring off the original transaction.
Let us explain with a simple example.
Say a stock XYZ is selling for $50 but is expected to fall to $40 sometime soon.
A trader can short 1,000 shares of the firm by borrowing them from a broker and selling them for $50,000 ($50 * 1000).
Later, when it falls to $40, they can buy back the same number of stocks for $40,000 ($40 * 1,000).
In the process, they make a total profit of $1,000.
There are a few requirements necessary to do this form of trading.
Firstly, opening a margin account with the broker to short securities is necessary.
Traders have to then put up collateral in the form of cash, eligible bonds, stocks, or mutual funds to borrow the equities they want to short.
Interest will also have to be paid for the duration they hold the shorted portfolio.
The quantum of this interest varies depending on how liquid the asset is. Usually, the higher the liquidity, the lower the rate.
Lastly, “naked” shorts are not allowed in the market due to US SEC regulations.
These are trades where the investor shorts a stock that their broker doesn’t hold with them.
Naked shorting can create market disruptions and has been disallowed for retail traders.
Can You Make Over 100% Shorting?
Despite the regulations against naked short selling, it is possible to have over 100% shorting.
Let’s first explain what the term means.
More than 100% shorting implies that more shares are short-sold than there are in the entire market.
While this may sound absurd, it is possible due to the nature of the beast. Let’s illustrate how this happens.
Trader A wants to short shares XYZ by borrowing from their broker, who locates them with client B and arranges the transaction.
When A sells shares, they get bought by C.
But what happens if C has a similar arrangement to B’s with their broker?
Along comes D, who borrows said stocks from C’s broker, who has no idea that A sold them to C without actually owning them.
As you can see, the same set of securities got shorted twice! In a real-life scenario, it can get much worse than this.
Can You Short ETFs?
Yes, ETFs can also be shorted. They are traded exactly like stocks in every way, and this is no different.
Doing this with ETFs has one major advantage over shares.
For securities, there is an “uptick rule” that disallows short selling if the price falls by more than 10%.
But there are no such limitations with ETFs.
Investors can capitalize on large downward trends in these funds, unlike shares.
Can You Short the S&P 500?
Yes, there are several ways to short the S&P 500, the easiest being to short-sell an ETF which tracks the index.
Another option is to buy an inverse ETF, an instrument that goes up when the index goes down and vice versa. We will explain this in more detail later on.
In the same vein, it is also possible to buy an inverse mutual fund.
If you prefer to trade in the derivatives market, taking a put option on an S&P 500 ETF is one more way to short it.
A put option gives its owner the right (but not obligation) to sell a certain financial asset at a pre-decided strike price at a specified time in the future.
For example, if the S&P 500 is tracking at 4,000, investors can buy a put option with a strike price of 4,000.
If the index falls to 3,800, the put option immediately becomes profitable since the owner still has the right to sell the shares at 4,000.
Can You Short Squeeze an ETF?
It is nearly impossible to short-squeeze an exchange-traded fund.
A short squeeze happens when the demand for a certain asset is much higher than its availability.
This can happen if many traders short it but suddenly reverse direction and start moving up.
Those investors would quickly need to cover their positions to avoid a major loss.
The sudden increase in buyers will push the price further, making it a vicious cycle.
Now, coming back to ETFs.
A short squeeze can happen with any asset class that can be shorted; hence, the concern should also extend to them.
However, unlike shares, ETF units can be created by market makers almost on the go.
This will increase the supply in the market to cater to the demand, thus preventing a short squeeze.
These market makers will likely already hold (at least partially) the underlying securities needed for the new ETF units created.
Hence there would be no disruption in the equity market either.
How to Short
There are several ways to do it, but the simplest is to borrow the ETF from your broker and sell it using a margin account.
Buying a put option on the ETF is one more way of shorting it.
As explained above, a put option will become profitable when the fund price falls.
Lastly, an inverse ETF performs in the opposite direction to the tracking index and is an inherent short position.
We cover this last method in detail below.
Inverse ETFs
Inverse ETFs move in the opposite direction of the index they track. They are also called short ETFs and bear ETFs.
For example, let us say the S&P 500 grows by 2% on a given day.
Its corresponding inverse ETF will go up by approximately the same percentage.
Traditional short selling requires borrowing shares. This meant having to offer collateral and paying interest.
For many investors, this is a very inconvenient way of trading. This is the reason why Inverse ETFs are popular.
These instruments are created using several types of derivatives, especially futures contracts.
These allow investors to buy or sell an asset at a certain price and time.
One drawback of inverse ETFs is that the underlying futures are usually very short-term instruments.
Fund managers buy and sell them every day.
Thus, there is no guarantee that an inverse ETF will track the underlying benchmark closely in the long term.
Another problem with them is that since the underlying assets are bought and sold daily, these instruments have higher expense ratios.
Bottom line – Inverse ETFs are best suited for day traders aiming for big gains.
What Brokerage Allows You to Short?
Not all brokers allow shorting. Hence, we have prepared a small list of those who do.
To choose the right broker, here are some parameters that one should keep in mind:
- Strength of the platform
- The ease with which a short position can be taken on them
- Borrowing fees and rates
- Minimum collateral
Here are the three best ones, based on the above criteria:
TD Ameritrade
TD Ameritrade is a popular trading platform offering web and mobile investing options.
It has a simple user interface and is designed for use by traders of all experience levels.
They allow short selling with a margin account.
A minimum of $2,000 is required to short-sell stocks through TD Ameritrade.
After depositing the initial fund and fulfilling other requirements, it takes about three days to create the account.
You can short most securities on Ameritrade, except for penny stocks.
Webull
Webull is a fully app-based brokerage.
It offers trading without commissions in securities and ETFs on its platform.
For short selling, investors need to open a margin account with a minimum balance of $2,000.
Unlike normal trading, shorting on Webull is not commission free.
Borrowing fees and interest need to be paid at a margin loan rate for these trades.
Charles Schwab
Charles Schwab is another great option for traders who want to short.
Investors must create a margin account with them and keep a minimum $2000 balance for these trades.
The broker offers to short in four markets, and it is possible to do it in stocks, futures, and ETFs.
However, their borrowing fees and margin rates are higher than competitors.
Is Shorting Worth It?
Shorting might be an excellent trading strategy in certain market conditions, but there are risks involved that traders need to keep in mind.
Unlimited Losses
While all investing involves risk, this trading strategy can potentially do limitless damage.
For example, buying a $10 share can, at worst, cause you to lose that much.
However, shorting it can cause a far bigger problem.
Consider this – what happens if the security suddenly rises to $50 or even $100?
The borrowed share will ultimately have to be replaced at some point.
If the price has risen to $50, there is a $10 – $50 = $40 loss. At $100, the trade would be $90 in the red!
There are no rules on how high a share can go. Hence traders should be careful to hedge when shorting.
Further, we explained earlier about short squeezes, which can cause even more trouble for those who have borrowed a large number of stocks.
Sudden Changes in Borrowing Costs
Large changes in margin lending rates can frequently happen, depending on liquidity.
It is possible to short a stock and then find that the borrowing rate has risen so much that it is unviable to hold it any longer.
Simultaneously, if the share starts rising in price, it can become a double whammy for the investor.
No Dividends
Short sellers are not eligible for dividends, despite holding equal risk.
Any dividend amount credited to them will go back to the stock owner’s account.
Margin Calls
Traders need to maintain a certain equity value, typically 30% to 35% of the worth of the shares borrowed, as collateral.
This requirement goes up if the stock’s price increases.
Hence, holding on to a shorting position would require the investor to quickly arrange funds and cover the required margin.
If it is not done, the brokerage might close the position partially so that it is brought down to the amount allowed as per available collateral.
Final Thoughts
It is possible to short-sell ETFs. The lack of uptick rules makes doing so even more attractive for traders.
There are several ways to short them – from borrowing stocks to taking put options or buying inverse ETFs.
However, each of these methods has its own unique problems, which we discussed in the article.
Moreover, any form of shorting can potentially lead to unlimited losses.
Therefore, for traders looking to use shorting as an investment strategy, it is best to understand the risks and hedge them before going ahead.
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