If you're an investor or considering your investment options, you're probably already familiar with one of the most fundamental rules of the game: buy low, sell high. But did you know some experienced investors actually manage to profit when share prices fall? It's an investment strategy known as short selling.
Short selling is somewhat controversial as an investment strategy, especially when investors pocket windfall profits. But what does shorting a stock mean, and how exactly do you short a stock?
Read on as we explain short selling in detail.
How to short a stock
Shorting a stock—or short selling—is, put simply, betting on a stock's devaluing to make a profit. First, you borrow shares of stock you want to short and sell them on the open market. Then, once the value falls as you had predicted, you buy back the same number of shares, return the borrowed stock to the original lender, and walk away with the difference.
For example, you think stock XYZ is overvalued and will soon drop in value, so you decide to borrow 10 shares for $100 each. Your broker then sells the shares for $1,000. You keep your short position open until the stock price falls, as you had predicted. Suppose the share price drops from $100 to $90. You buy back the 10 shares for $900 and return them to the lender, pocketing the difference of $100.
Using the same example, if you were to predict incorrectly, you would lose a substantial amount. If you sold 10 shares for $1,000 and the stock rises to $110 per share, you would have to buy back the 10 shares for the higher price of $1,100 and lose $100.
Costs of short selling stocks explained
Short selling stocks also involves additional costs, including the fee or commission your brokerage firm charges for finding shares to borrow and selling them on the open market. To short sell a stock, you first need to open a margin account, and the margin requirements associated with the trade can be costly, too.
If shares of the stock you want to short are scarce, a broker may charge what's known as a "hard to borrow" fee. You’re also responsible for paying dividend payments to the lender of the shares and other expenses that occur on account of the borrowed shares.
Pros and cons of short selling
- Potential profit in a bear market
- Hedge a long position
- A small amount of initial capital
- Potentially unlimited losses
- Margin interest
- Unique regulations
Why should I sell short?
When investors decide to short a stock, they take advantage of a downtick in the market. Some investors will short a stock based on speculation that the price of the stock will fall; others will "go short" to hedge their long positions. If you take a long position that you believe to be risky, you can short shares in a similar industry to lower your chance of losing profit.
What are the risks of short selling?
As a trading strategy, short selling involves significant risks. When you take a long position, the maximum risk you take is the total price of the shares you buy, with a theoretically unlimited reward. On the other hand, with a short sale, the risk is theoretically infinite, and the potential reward maximizes at 100% of the initial sale of the shares. Short selling can be risky when the market is volatile, too. Price fluctuations could benefit short sellers, but they could also pose a risk if the share prices rise.
One of the major risks of short selling stocks is a short squeeze. Short squeezes occur when you speculate that a stock’s value will significantly drop and heavily short the shares, only to find the value of the shares actually rises. You then scramble to buy back shares, driving up demand and, in turn, prices even higher as other investors in short positions do the same.
The controversy surrounding short selling
In practice, short selling doesn't have the best reputation. Since short selling involves betting against the market, technically speaking, some believe short sellers are out to profit by purposefully making the market crash or negatively affecting the economy.
Short selling is not just used to profit from a stock's downtick; many investors use it to hedge their risk. Short selling can also benefit the market by providing liquidity and introducing a healthy dose of realism into investors' expectations. If expectations of a company are overly optimistic and the price overvalued, short sellers can provide skepticism that keeps the market efficient.
While short selling was prohibited for many years—from 1938 to 2007, specifically—these days the Securities and Exchange Commission allows investors to go short as long as they stay within specific regulations.
A potential alternative to short selling for more risk-averse investors is put options. Puts give you the chance to sell at a predetermined price, called the strike price. If the share is valued at a lower price, you can buy the shares for the lower price and sell them for the higher strike price. Puts allow you to take advantage of a downward trend but involve much less risk. Why? Because the most you can lose is the initial investment of what you paid for the put option.
FAQs for shorting a stock:
When does short selling make sense?
The right time to short stocks is when the market is trending downward, also known as a bear market. Investors will also go short when a company's fundamentals show signs of deteriorating (for example, if revenue is falling or rising costs).
Another way to know if it's a good time to short sell is when the 50-day moving average falls below the 200-day moving average, creating a "death cross."
How is short selling different from regular investing?
Short selling has significantly more risk, as the potential losses when you short a stock are theoretically infinite. Short selling has unique rules and regulations, namely what's known as the "alternative uptick," which prohibits shorting an asset whose value has fallen by 10% or more in one day.
How long can I short a stock?
No regulations currently restrict how long you can short a stock, although the costs to keep a short position open could limit your options. Typically, the fees charged by a brokerage firm to short a stock lead investors to close out their short positions if they can no longer afford to wait for the share value to decline, as speculated.
Does shorting a stock bring the price down?
As an individual investor partaking in short selling, the chances of you causing a stock price to plummet is limited except in extreme cases. So don't worry about harming the market if you decide to short a stock.
What is the maximum profit you can make from shorting a stock?
The most you can make on a short sale is 100% of the initial price of the shares (this would be if the share's value fell to zero). The actual net profit of shorting a stock would be less because of the costs to facilitate the trade.
Why is it called short selling?
Typical investments are called “long positions” or “going long” because you’re betting on the market improving over time. Long positions are also known as “buy low, sell high” or “buy and hold” strategies that allow you to profit over time. Short selling is the opposite of this, as you’re betting against the stock market. You ideally don’t want to hold a short position for an extended period; the faster you can end the trade, the better.
Is short selling bad?
Short selling may get a bad rap, but as an investment strategy, it’s perfectly legal and even brings liquidity to the stock market, making it more efficient.
The bottom line
Stock trading can be complex, and you can use various strategies to grow your portfolio. Short selling, when done successfully, is one way to continue to garner returns even when stock prices are falling. Short selling can be risky, but you can also use it to hedge against risk in your other investments.