If you've ever heard the saying, "buy low, sell high," you already know the basics of successfully investing in the stock market. That is, you buy in cheap, wait for your stock's value to increase, and sell it for a profit.
But what about profiting from a stock's decrease in value? Or, more specifically, an advanced investment strategy that's known as "shorting stocks."
What is shorting a stock? Read on as we look at how to short sell stocks in detail.
What is shorting a stock?
Shorting a stock or short selling is, in short (pardon the pun), betting against a stock. If you anticipate a stock falling in value, you can borrow shares of the stock through a broker, sell those shares, and later buy back the stock at a lower price to return to the lender, pocketing the difference.
While short selling may seem simple, usually only experienced investors take advantage of this strategy. Why? It involves a high level of risk, not to mention the need to pay extremely close attention to the price movements you need to turn a profit. Some investors use short selling to reduce the risk of owning stocks or "long positions."
What is short selling in a share market?
To short sell, you first need to borrow shares of stock—stock that’s most likely currently scarce—through your brokerage firm. Borrowing shares to short sell is known as "margin trading" or trading on the margin, and it requires you to pay interest for the privilege of borrowing shares through your broker.
How does a short sale work?
The process of short selling is relatively simple once you've identified the stock you want to short.
- Choose the stock you believe will decline in value.
- Make sure you have a margin account before you can short sell.
- Contact your broker to borrow shares of that stock. Remember, you're responsible for paying margin requirements on the margin account.
- Your broker sells the shares on the open market on your behalf.
- Decide when to close out your short position,
- Buy back the borrowed shares at a price that's now ideally lower than when you sold them.
- Return the borrowed stock to the original lender.
While short selling can quickly result in significant profits, you also assume a high degree of risk. So it's no surprise that most experts consider it a trading strategy for experienced traders only.
Short selling stock examples
Transaction example
Here's a hypothetical example of short selling: You find XYZ stock valued at $100 per share and believe the value will fall, so you decide to open a short position. Through your brokerage firm, you borrow 100 shares at $100 per share and then sell the shares for a total of $10,000.
Let's say you're correct in your speculation, and the XYZ stock price drops to $70 per share. You then buy back the 100 shares for $7,000 and return the borrowed shares to the lender. That leaves you with the difference, totaling $3,000.
Need a real-world example?
Say you believe Meta stock is overvalued at a price of $310 per share, and you borrow 10 shares and sell them for $3,110. If the stock declines to $200 per share, you can buy back the shares at the lower price for a total of $2,000.
After returning the 10 borrowed shares to the lender, you'd have profited the difference of $1,110 from shorting Meta stock.
Example of a short squeeze
Unfortunately, shorting a stock doesn't always go as planned, as you can't predict a stock's future value to a tee. If your speculation is incorrect, but you still want to hold your short position, you must cover margin costs. If you lose too much money, your broker may even place a margin call, where you are required to deposit more money into your brokerage account.
You can also find yourself in a short squeeze, where the stock price rises dramatically. When this happens, the potential losses for the short seller are astronomical.
For example, in 2008, luxury sports car manufacturer Porsche attempted to gain majority control of Volkswagen. Investors knew that if Porsche were to succeed, the market price of Volkswagen stock would fall in value. Porsche then revealed it had secretly acquired 70 percent of Volkswagen through derivatives. Investors scrambled to buy back borrowed shares of Volkswagen stock, creating a feedback loop.
Suddenly, there were very few shares of Volkswagen stock in the market and high demand of investors who needed to buy shares to return to lenders. Volkswagen's stock then skyrocketed as investors were frantic to repurchase shares at a higher price. In a short squeeze, the stock typically falls to its normal range within several months, as did Volkwagen's.
What is the ideal environment for shorting stocks?
Remember, short selling comes with significant risk, and while substantial earnings are possible, you can also suffer major losses. The key to successfully shorting stock for a profit? Timing.
The ideal time to profit from shorting stocks is during a downward trend or a "bear market." A bear market occurs when a stock's 50-day-moving average is below its 200-day-moving average. This sharp decline in stock values is a "death cross," a strong indicator of a bear market and the perfect time to sell short.
Another ideal situation for short selling is when a stock is drastically overvalued. Suppose the market has high and overly optimistic expectations. The share price may be much higher than its actual worth. Once it becomes clear that the public expectations of the companies' performance are unreachable, the stock's value will undoubtedly fall.
Short selling vs. puts
Put options are similar to short selling, as they also profit from a decline in a stock's value. A put allows you to sell an asset at an agreed price, known as the "strike price." If the stock's value falls below the strike price, the put's value increases. If the stock is above the strike price, you should exercise the right to sell the put, and the option will expire.
Both short selling and put options take advantage of a bear market, but put options are generally less risky. With put options, the premium paid for the position is the most you can lose.
In contrast, short selling entails potentially unlimited losses if the value of the stock rises rather than falls. If you want to play it safe when hedging a long position, put options are the way to go.
The bottom line
Remember, short selling is a way for you to take advantage of a declining market.
Investing your money always comes with some risk, no matter the stock. Short selling can be a risky investment strategy, but it can also mitigate your risk on a long position depending on how you want to short trade.
