How to short sell shares in a registered account?

What is short selling?

Short selling, or 'shorting stocks', is a strategy employed by investors who anticipate a decline in the value of a security. This method involves making a profit by selling 'borrowed' stock at a higher price and subsequently repurchasing it at the expected lower price within a fixed time period before returning the stock to the owner. The difference between the higher selling price and the lower purchase price is retained as profit. However, it is important to note that the short seller may incur a fee for borrowing the stock from the brokerage firm.

Why would I want to short sell securities?

The primary reason for short selling is to profit from the expected decline in the value of a security. By selling borrowed stock at a higher price and repurchasing it at a lower price, the investor can capitalize on a falling share price in a declining market.

Short selling, when successful, yields significant gains due to the leverage associated with borrowing stocks. However, it multiplies both gains and potential losses. The short seller speculates on a stock's decline, but numerous factors can influence its price. Choosing the right stock and timeframe is challenging, and if the market moves unfavorably, losses can be substantial.

Unlike a regular stock purchase, where losses are capped at zero, short selling has unlimited potential losses if the stock's value rises. Alternatively, patience and buying at a lower price without shorting may be considered.

How can I short sell in a registered account?

Registered accounts and TFSAs cannot be used for short selling. To short sell stock, investors need to have a margin account and be approved for short selling in which case a short selling account is added.

So, how can registered account holders take advantage of declining stock values and a bearish market?

There are two alternatives available to those with non-registered accounts like a Registered Retirement Savings Plan (RRSP) or a Tax-Free Savings Account (TFSA):

• Buying inverse ETFs or leveraged inverse ETFs.
• Buying put options.

What are inverse ETFs?

Inverse ETFs and leveraged inverse ETFs are exchange traded funds (ETFs) that allow investors to make money when the market or underlying sector is in decline. The downside risk is limited to the amount invested in the ETF, and there are no time or term limits on the security; the ETF can be sold at any time.

While an inverse ETF may not be specific to a particular stock, choosing one from a specific industry or sector can serve as a replacement for an individual stock. For instance, if an investor anticipates a decline in the stock price of ABC Financial Services Inc., they could opt for an inverse ETF from the financial services sector. The assumption is that any decline will be sector-wide, impacting all companies working in that area. Consequently, the unit price of the inverse ETF is expected to increase in value when the financial services sector’s ETF unit price decreases.

What are put options?

A put option is a contract that gives the option buyer the right to sell a specified number of shares if they reach a pre-determined lower price (called the strike price) within a fixed time frame. The put option buyer pays a premium for this right, anticipating a decrease in the underlying security's price towards or below the strike price. The buyer can then sell or exercise the put option at any time until the expiration date. Exercising put options requires a margin account with the appropriate option level approval.

When held in a TFSA or registered account, the put option buyer must sell before the expiration date if the share price is below the strike price to close their position and realize the profit from the share price decrease.

The maximum loss for the put option buyer is limited to the premium they paid for the put if, at expiration, the price of the underlying security is higher than the strike price. Buying put options can be done with limited capital and does not require a margin account.

Not all stocks and ETFs are options eligible, but many qualify. When executing a put option purchase in a registered or TFSA account, there are three important things to remember:

• Strike price - This is the price that has been set for the sale to be assigned. If the stock price falls to or below it, the put option buyer is obliged to exercise the contract and sell the stock at that price at expiration. Since that is not a permitted transaction for the accounts mentioned above, the investor must sell the put option before expiration to close their position.
• Premium - The premium is the amount per share that the buyer of the put option pays at the start of the contract for the right to sell at the strike price.
• Expiration date - The expiration date is the date at which the contract ends. If the underlying security does not reach the strike price by then, the put option expires worthless and the buyer loses the paid premium. The put option buyer is responsible for closing their position by selling their put option before expiration if the security price has passed or is at risk of reaching the strike price.

Why use put options?

There are two main reasons why investors might consider trading put options as part of their investment strategy:

• Speculation - A put option can be used to speculate on the direction of the underlying security, hoping it will decrease in value. The advantage of using a put option is that the investor requires less capital to purchase the put option versus short selling the shares. An investor can control many shares with the cost of a premium to purchase the put option (leverage). If the price of the security increases instead, the put option buyer will only lose the amount of premium they paid to buy it.
• Hedging purposes - Put options can be used to hedge against a possible share price decline on an existing holding. As an example, an investor has a stock holding with an upcoming earnings announcement that could lead the security price to either increase or decrease. Or, the investor would like to protect themselves in case of a short-term price correction but still benefit from an upswing if they are wrong with their analysis. In either case, the put option serves as an insurance policy to protect the put option buyer from a decrease in the security price.

Put options – an example

An investor with a registered account expects the share price of ABC Company shares will decrease when the company releases its quarterly report in ten days. Our investor thinks that the current $50 share price is high and wants to take advantage of the price drop by buying a put option. The example will assume no commissions were paid.

Day 1:

The investor buys a put option on ABC Company stock that expires in 30 days with a strike price of $49 and a premium of $2 per share.

Day 10:

Scenario #1: ABC Company reports declining earnings and the stock price drops to $44. Our investor sells their put option for $6 for a net profit of $400 and a return of 200%.

Scenario #2: The investor is wrong. ABC Company reports increasing earnings, and the stock price increases to $54 and remains at that price until expiration.

Managing risk by investing in inverse ETFs and put options

When it comes to managing our investment accounts, we often think about the process simply in terms of limiting the potential downside risks. The focus is on buying low and selling high – playing the waiting game and making sure that our portfolios are diversified enough to weather market storms.

Inverse ETFs and buying put options offer self-directed investors with registered accounts another strategy: the opportunity to proactively trade when the investment climate is bearish and stock prices are falling. Remember that investing always carries some risk. The key is to have a plan, do your research, and invest wisely!