Short selling is a way to invest so that you can attempt to profit when the price of a security — such as a stock — declines.
What does it mean to short sell a stock?
Rather than buying a stock (called going “long”) and then selling later, going short reverses that order. A short seller borrows stock from a broker and sells that into the market. Later, they will hope to buy back that stock at a cheaper price and return the borrowed stock in an effort to profit on the difference in prices.
Short selling, or shorting, a stock or another type of security is straightforward in theory, but it presents different costs and risks from going long. Plus, shorting is sometimes seen as a controversial tactic.
How to short a stock
When you short a stock, you’re betting on its decline, and to do so, you effectively sell stock you don’t have into the market. Your broker can lend you this stock if it’s available to borrow. If the stock declines, you can repurchase it and profit on the difference between sell and buy prices.
So going short really only flips the order of your buy-sell transaction into a sell-buy transaction. In other words, instead of “buying low and selling high,” you’re trying to “sell high and buy low.”
Here are the steps to short a stock:
- Find the stock you want to short: You’ll need to do research to find a stock that you think is poised to decline.
- Place a sell order: To short a stock, you’ll place an order to sell stock that you don’t own. When entering your sell order, many brokers won’t distinguish between a short sale and a regular sale. So you’ll enter the order just as if you were selling stock you owned. The short position will typically show up in your account as a negative number of shares (e.g., -100 shares of XYZ stock).
- Wait for the stock to decline: After you’ve shorted the stock, you’ll wait for it to dip in price, ideally. You’ll have to decide when to close the position and at what price.
- Buy the stock and close the position: When you’re ready to close the position, buy the stock just as you would if you were going long. This will automatically close out the negative short position. The difference in your sell and buy prices is your profit (or loss).
To short a stock, you’ll need to have margin trading enabled on your account, allowing you to borrow money. The total value of the stock you short will count as a margin loan from your account, meaning you’ll pay interest on the borrowing. So you’ll need to have enough margin capacity, or equity, to support the loan.
In addition, you’ll have to pay a “cost of borrow” for the stock, which may be a few percent a year on your total loan, though it could be much higher. That’s a fee paid to the broker for the service of finding stock to sell short. Plus, you’re on the hook for any dividends paid by the company. All those fees will be rolled into your margin balance.
Shorting a stock: Example
Let’s run through an example to see how it all works and how much you could make if you short a stock.
Imagine you want to short the stock XYZ, which now trades at $100 a share. You have enough margin capacity to short 100 shares comfortably. So you sell those shares in the market.
You’ll have -100 shares of XYZ in your account and a margin balance of $10,000 (100 shares * $100 a share). You’ll also have the cash proceeds of $10,000 credited to your account, since you sold the stock. You’ll need this cash in your account to repurchase the stock later.
Let’s say XYZ falls to $60 a share after reporting a poor outlook. You can repurchase the stock for $6,000, and you’ll pocket the difference of $4,000 between your sale and purchase. You’ll also have to repay the stock’s cost of borrow or any dividends paid while you were short.
However, if the stock rose to $140 and you wanted to close the position, you’ll need to pay $14,000 to repurchase the 100 shares. You’ll have to come up with the $4,000, perhaps from a margin account, and you’re still on the hook for the cost of borrow and any dividends paid.
When you’re shorting stock, you’re borrowing against the equity in your account. This means that you could suffer a margin call from your broker. You’ll have to put more cash in your account or liquidate positions, or if you’re unable to do so, your broker may liquidate positions for you. You may be forced to close your short position against your wishes.
Pros and cons of short selling stocks
Short selling has some positives, especially for advanced investors who can use the technique properly. The disadvantages can be numerous, however.
Advantages of short selling
Short selling provides benefits to individual investors as well as to the market as a whole.
- Profit on a stock’s decline: Short selling allows investors to profit on the decline of a stock. It provides another tool in an investor’s toolkit, allowing investors to make money when they discover an overvalued stock.
- Keep a check on fraud: Short selling helps keep fraudulent companies from ripping off investors. By researching fraudulent companies and publicizing their research, short sellers can keep other investors from buying these stocks.
- Create an orderly and liquid market: Short sellers help keep the stock market orderly and provide liquidity for buyers, allowing the market to function better. Plus, this benefits long-term investors who can buy at more stable prices and amass stakes at lower prices, all else equal.
- Can be used to hedge a long portfolio: One advantage for advanced investors is that shorting can offset some of the risks of investing. For example, by having some short exposure, investors can profit when the market declines. They can sell their profitable short positions for cash, and then add to their long positions at lower prices.
Disadvantages of short selling
- Can spread false information: Unscrupulous short sellers can spread false information in the market and push a stock’s price down without reason. Then they can take their profit and move on. Of course, this is no different than “pump-and-dump” schemes on the long side to get investors to buy poor or overvalued stocks.
- Can have unlimited losses: Your risk is theoretically uncapped, since the stock you’ve shorted can keep rising. You could lose more than you’ve put into the trade.
- Can lose more than you could make: While you can have unlimited losses, the most you can ever earn on a short trade is the total value of the shorted stock. So your upside-to-downside is skewed in favor of losses.
- Must pay additional costs: You’ll have to pay extra costs to keep your short trade – the cost of borrow, the margin loan and any dividends paid. These add up over time.
- Tough to make money: The stock market as a whole tends to go up over time, so short sellers face a situation that’s already set up against them in the long run.
- Can attract hate from other investors: Short sellers can face a lot of animosity from other investors, and there’s a lot of skepticism about short sellers, as if they’re betting against success.
Costs and risks of short selling stocks
Short selling presents numerous costs and risks for investors. Here are some of the major ones.
Unlimited losses
The potential gain for long investors showcases the main risk for short sellers: The stock can continue rising indefinitely. When you sell a stock short, there’s theoretically the potential for unlimited losses. That’s because the stock can continue rising and rising over time, wiping out other gains.
For example, imagine being a short seller in Amazon or Apple over the last decade, as those stocks soared. A buyer’s long-term gains become your long-term losses. That said, short sellers may jump in for short periods of time when a stock looks overvalued and profit on a decline.
Short squeezes
In a worst-case scenario, a stock may experience a short squeeze, which could be ruinous to a short seller. A short squeeze occurs when the stock rises rapidly, forcing short sellers to close their position. Short sellers may be rushing to avoid a soaring stock or they may be forced to buy back stock as their losses mount and the equity for a margin loan in their account dwindles.
If enough of the stock is sold short and the stock begins to rise, it can kick off a period of soaring stock prices – sometimes running hundreds of percent higher. As the short squeeze hurts more and more short sellers, they are forced to buy stock at any price, pushing the price still higher.
That was partly the situation with video game retailer GameStop in early 2021, as a massive short squeeze sent its stock spiraling upward forcing many traders to cover their short positions.
Less potential gain
Another downside of shorting a stock is that you have less potential gain than going long the stock. That’s due to simple math.
For example, compare the potential gain on buying 100 shares of fictional ABC stock trading at $100 per share. If the stock rises to $200, you will have made $10,000 from your initial investment. If the shares continue higher, you’ll make an additional $10,000 for every $100 rise in the stock price.
The stock can continue rising over years if the company is well run. There’s literally no cap on the upside of a stock, and stocks have made millionaires out of many people over time.
In contrast, the potential gain for a short is limited to the initial amount shorted. For example, if you short 100 shares of ABC at $100 per share, the most you could gain is $10,000 in total, and that’s only if the company goes to zero, or is basically bankrupted or completely fraudulent.
So the most you could profit in a short position is the initial value of the stock you shorted. And you have smaller costs chipping away at your gains as long as you maintain the short.
Other costs
Besides these costs, short sellers have others that increase short-selling’s cost relative to going long a security:
- Margin loans: When you short a stock, you rack up a margin loan for the value of the stock you’ve borrowed. You’ll pay the broker’s rates on margin loans, which may run as high as 10 percent or so annually.
- Cost of borrow: Short sellers are also charged a “cost of borrow” for shares they are lent. That may be a charge of just a few percent annually, though on highly popular shorted stocks, it may surge over 20 percent. This fee typically goes into the pocket of your broker, though at least one brokerage (Interactive Brokers) splits that fee with the stock’s owner.
- Dividends: If you short a stock that pays a dividend, you’ll also have to pay back any dividends that were paid out during the period when you shorted the stock. That could add another few percent annually to the cost of shorting the stock.
The market’s long-term upward bias
Plus, short sellers face a stock market that has a long-term upward bias, even if many of its companies do fail.
“The deck is actually stacked against the short seller, as stock prices do typically rise,” says Robert R. Johnson, professor of finance at Creighton University, pointing to the S&P 500 index’s long-term record of rising about 10 percent annually since the 1920s. “Someone who consistently short sells the market is consistently a loser.”
So there’s a clear asymmetry between the potential profits of going long and going short. To succeed over time, you’ll have to identify and repeatedly pick the losing stocks.
Is short selling wrong?
Shorting is sometimes seen as an attack on the stock market, because certain investors view it as betting on failure rather than wagering on success. If you mention short selling to an investor, you’re likely to get one of two responses:
- “Short sellers provide a valuable service by keeping stocks from running too high and by exposing frauds.”
- “Short sellers spread false rumors and sow uncertainty in profitable and socially valuable companies for their own profit.”
It’s a stark dichotomy, and while there’s some gray area, it won’t seem like it if you ask investors who have been on the receiving end of a short seller’s attack. Still, both points can hold true.
Short sellers get a bad rap because “they are viewed as betting against the success of a business, and, to many, that is an ‘un-American’ attitude,” Johnson says. “Since short sellers succeed when stock prices decline, they are viewed negatively by many, even seen as nefarious.”
Yet, short selling can limit the rise of stocks, and prevent them from running into a speculative frenzy, helping the market maintain order. Shorts may also bring to light valuable information about companies that are undertaking fraudulent activity or accounting shenanigans, so that investors as a whole have more complete information and may properly price a company.
And short sellers bring another positive to the market, too, Johnson says. “The most important value of short selling is that it provides markets with a greater degree of liquidity. More investors stand ready to buy and sell,” he says.
On the other hand, some very public short sellers are happy to spread rumors or opinions that try to discredit profitable companies and scare the market into selling them. This practice hurts the company’s shareholders, causing their stock to trade below where it otherwise would trade. The short seller can then profit on the fear or doubt and book a profitable short sale.
Is short selling right for you?
Short selling requires a lot of work and knowledge to succeed, and it’s not really a good idea for individual investors, who must match their wits against some of the sharpest investing minds. Given the challenges, even many of the professionals find shorting to be a grueling effort.
“It is most certainly not an activity that is appropriate for most investors,” Johnson says. “Short selling is really the purview of professional investors and hedge funds.”
Still, if you’re set on betting against a stock, you may be able to use put options to limit the worst risk of shorting, namely, uncapped losses. One strategy (buying a put option) allows you to profit on the decline of a stock and limit how much you’ll lose on the position. Options present other risks, however, that investors need to be fully aware of before they start trading them.
And most investors would do better sticking to a long-only portfolio.
“The good news is that one can make investing very simple, yet get great results,” Johnson says. “The best thing for most investors is to invest in a low-fee, broadly diversified, stock market index fund.”
Bottom line
Short selling can be lucrative, but it can take nerves of steel to weather the rise of the stock market. Given the risks, short sellers have to be unusually careful and well informed, lest they stumble into a stock that’s about to bound higher for years. So short selling is usually best left to sophisticated investors who have tons of research, deep pockets and a higher risk tolerance.
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Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
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Short selling: How to short sell stocks - Bankrate.com
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