If you’re looking to build your financial portfolio, you’ve probably heard your fair share of advice telling you to buy low and sell high or to invest in ETFs. If the market is declining, it can be disheartening if there are few opportunities to get a return in the stock market. In these cases, some investors take advantage of a downtick in the market using a trading strategy called short selling.
So, what is shorting a stock and what are the steps to doing it?
What is short selling?
Short selling is—in short—when you bet against a stock. You first borrow shares of stock from a lender, sell the borrowed stock, and then buy back the shares at a lower price assuming your speculation is correct. You then pocket the difference between the sale of the borrowed shares and the repurchase at a lower price.
Short selling for dummies
If short selling stocks sounds like a reasonable investment strategy to you, you’re probably wondering how to actually short a stock.
- Ensure you have a margin account with your broker; this is necessary to start a short sale. You will also be responsible for margin requirements on the trade.
- Contact your broker to facilitate borrowing the desired shares of stock. Your brokerage firm will locate a lender and sell the shares of the particular stock on the open market for you.
- Once your broker sells the shares on the open market, the money from the sale is deposited in your account. You are now in a short position.
- Once the share price declines, you buy back the shares for a lower price to close out your short position.
- You return the shares to the lender and keep the difference as your profit from the trade.
Making money from shorting stocks explained
You can make decent profits from a short sale if your timing is right, especially in a market sector with volatility. If you believe the stock's current price is overvalued, you can profit quickly in the short term from short selling when a stock price drops suddenly.
Another way to take a short position is through a put option, which is significantly less risky than short selling.
What are the costs of a short sale?
Remember that margin account you need to go short? You'll have to pay interest on the margin of the borrowed shares. Margin interest is an expected cost on all short trades, but you should also be prepared to pay a fee if the shares are deemed "hard to borrow" (meaning there are limited shares), and it's difficult for the broker to find a lender for the short sale. You are also on the hook for paying dividends on the shares and any other events on the stock you are shorting.
Shorting stocks FAQs
Why do investors go short?
You can go short for a variety of reasons. One of those is speculation, or when you believe that the value of a stock will fall in the future. Short positions are also used as a hedge against the risk of a long position. Individual investors will utilize this and hedge funds to lower potential losses of a long position. In recent years, Wall Street hedge funds have used short selling to lessen the amount of risk involved.
What is the maximum profit you can make from going short?
The most you can make from going short is 100% of the initial sale of the short stock. This means that if the value of the shares falls to zero, you pocket the initial sale of the now-worthless shares.
Can you lose more than you invested in a short sale?
In short, yes. The potential for significant losses makes short selling a risky trading strategy and is typically recommended only if you are an experienced investor.
If a stock price rises, you lose the difference between the stock’s purchase price and the higher price when you close out your short position, plus any additional fees and interest payments needed to execute the trading strategy.
With a short trade, the stock’s value could theoretically rise infinitely, and therefore you could have unlimited losses. If your speculation is wrong and the share values increase, you could find yourself in a dreaded short squeeze, where investors rush to buy back shares and drive the demand and price of the stock even higher.
Is short selling bad for the economy? Short selling controversy explained
Short selling is controversial because some believe it is unethical to bet against the stock market. Some believe short sellers will also intentionally attempt to make a company fail or use other unethical market manipulations for personal profit. In reality, short selling helps keep investors' expectations realistic by providing necessary scrutiny of stocks. It also adds a level of liquidity to the market that often makes for increased efficiency.
Why do sellers borrow shares?
There are a limited number of shares for a stock, so you have to borrow shares from a lender in a long position. You pay the lender interest for the privilege to borrow the shares to go short.
Trading with borrowed shares is also referred to as margin trading, and borrowers are responsible for margin interest.
What is a short squeeze?
A short squeeze is one of the risks of short selling. With a short squeeze, if you are wrong in your speculation of a fall in share value and the price of stock suddenly rises, you can find yourself in a feedback loop.
As other short sellers scramble to buy back borrowed shares, the demand for the scarce shares rises along with the price of the stock. Everyone in a short position then keeps driving the prices higher as they look for shares to buy back to close out their short positions.
The bottom line
Short selling requires you to be aware of a share’s market price while making the trade and have a high-risk tolerance because of the potential for unlimited losses.
Stock trading can be a potential way to build your wealth (albeit somewhat risky), and short selling is an alternative trading strategy that you can use to profit even in a downtick.