Can You Short Sell ETFs? (2024)

ETFs (an acronym for exchange-traded funds) are treated like stock on exchanges; as such, they are also allowed to be sold short. Short selling is the process of selling shares that you don't own, but have instead borrowed, likely from a brokerage.

Understanding ETFs

ETFs are investment funds that trade on stock exchanges, combining features of mutual funds and individual stocks. These funds pool money from numerous investors to buy a diversified portfolio of stocks, bonds, or other assets. ETFs offer investors exposure to a broad range of assets, sectors, or investment strategies, providing diversification and liquidity.

In the context of ETFs, short selling allows investors to profit from a potential decrease in the ETF's value by borrowing and selling shares. This strategy can be employed to hedge against market downturns or to capitalize on perceived market trends. We'll talk more about why investors would short sell an ETF later in this article.

Understanding Short Selling

Short selling is a trading strategy where an investor borrows a security and sells it with the anticipation that its price will decline. The goal is to later repurchase the security at a lower price, return it to the lender, and pocket the difference as profit. This strategy is often used to capitalize on bearish market expectations, hedge against potential losses, or exploit overvalued securities.

One benefit ETFs provide to the average investor is ease of entry. These products do not have uptick rules, so investors can decide to short the shares even if the market is on a downtrend. What this means is that rather than waiting for a stock to trade above its last executed price (or an uptick), the investor can short sell the shares at the next available bid and immediately enter into the short position.

This is important for investors wishing for quick entry to capitalize on the market's downward momentum. With regular stocks, the investor would not be able to enter into the position if the downward pressure was great.

Motivation to Short Sell ETFs

Most people short sell shares for two reasons:

1. They expect the share price to decline. Short-sellers hope to sell shares at a high price today and use the proceeds to buy back the borrowed shares at a lower price sometime in the future in a bid to profit.
2. They want to hedge or offset a position held in another security. For example, if you have sold a put option, an offsetting position would be to short sell the underlying security.
   

Steps to Short Sell ETF

Shorting an ETF involves a series of steps. Here's a very general overview on how to short an ETF:

1. Open a Margin Account: Short selling usually requires a margin account, which allows you to borrow securities. Not all brokerage accounts automatically come with margin privileges, so you may need to apply for it even if you already have accounts open with a brokerage firm.
2. Check Borrowing Availability: Verify with your broker that the specific ETF you want to short is available for borrowing. Not all ETFs may be available for short selling for several reasons, such as liquidity constraints.
3. Place a Short Sell Order: Once you've confirmed availability, place a short sell order through your brokerage platform. Indicate the quantity of shares you want to short and set the order type (limit or market order).
4. Monitor the Trade: Keep a close eye on the market and the performance of the ETF. Set stop-loss orders to manage potential losses, and ensure your account is perpetually meeting margin requirements.
5. Buy to Cover: When you decide to close your short position, you'll need to "buy to cover." This involves purchasing the same number of shares that you initially borrowed and sold.
6. Account for Dividends: Note that if the ETF pays dividends, you may be required to compensate the lender for the dividend payments during the time you held the short position.

Downsides to Short Selling ETFs

We'll wrap up the article by discussing downsides to short selling. Though this list is presented as the limitations to short-selling ETFs specifically, these cons can often be attributed to short-selling different types of securities as well.

1. Unlimited Loss Potential: When you short-sell an ETF, the potential loss is theoretically unlimited. If the price of the ETF rises significantly, there's no cap on how much you could lose. This is in contrast to buying a stock, where the maximum loss is limited to the initial investment.
2. Dividend Payments: As a short seller, you might be required to pay any dividends distributed by the ETF to its shareholders. This additional cost can add to your losses or at least be another type of "cost" to consider.
3. Margin Calls: If the price of the ETF rises, your broker may issue a margin call. This would require you to deposit additional funds to cover potential losses. Failure to meet a margin call can result in forced liquidation of your position (meaning your investments are sold off).
4. Short Squeeze: A short squeeze occurs when there is a rapid increase in the price of a heavily shorted ETF. Short sellers rush to cover their positions, buying shares in the market, which can lead to a further price increase. This situation can result in substantial losses for short sellers.
5. Borrowing Costs: Short sellers typically borrow shares from their broker to sell them in the market. There are costs associated with borrowing, so you may end up losing money because of fees even if your trade is profitable.

The Bottom Line

Yes, you can short ETFs. Short selling ETFs aims to provide returns that move in the opposite direction of a specific underlying index or asset class. This strategy is suitable for investors seeking to hedge against market downturns or capitalize on bearish market trends.