How to Short a Stock: Defined and Explained
Shorting a stock, also known as short selling, is one way to potentially profit from a stock’s price decline.
When investors think a stock’s price will fall, they can sell borrowed shares, repurchase them at a lower price, and potentially pocket the difference as profit. This strategy is popular among experienced and risk-tolerant investors who conduct thorough market analysis before taking a short position.
For new investors, the idea of making trades that can be profitable even when the price falls may sound strange. After all, the traditional way to profit in financial markets is a buy-and-hold strategy: purchasing a security, holding it, and selling it later for a higher price.
However, by understanding how short selling works, investors can utilize new strategies to potentially bolster their financial portfolios.
Key Points
• Shorting a stock involves borrowing shares to sell at a high price, with the expectation of repurchasing them later at a lower price, and pocketing the difference.
• A short squeeze occurs when a sudden price increase forces short sellers to buy shares back quickly, further driving up the stock price.
• The strategy can be risky, as potential losses are unlimited if the stock price rises instead of falling.
• Alternatives to short selling include purchasing put options, which allow investors to profit from stock price declines without borrowing shares.
• Short selling may serve as a hedge against other investments, but it requires careful consideration due to its high risk and potential costs.
What Is Shorting a Stock?
A trader shorts a stock when they think its price will fall. Shorting involves borrowing the stock from a brokerage, selling it, and then buying it when the price is lower than when they sold. The trader then returns the shares to the brokerage and may realize a profit, provided the shares sold for more than they were bought back for.
Shorting a stock allows investors to take a position that anticipates a stock’s future share price will be lower than its current price. It’s the opposite of going “long” on a stock, where an investor buys shares with the expectation that the stock price will increase.
Short selling can be risky because if the stock price goes up instead of down, the investor will have to buy the shares at a higher price and may lose money.
Recommended: Short Position vs Long Position, Explained
Example of Shorting a Stock
Suppose an investor identifies a company they think is overvalued, and believes its share price will decline. The trader borrows 100 shares of stock in the company from their brokerage, and sells the shares for $10 per share. This amounts to $1,000 (plus any applicable brokerage fees).
In this scenario, the investor’s short strategy works, and the price falls to $9 per share. The investor can then buy back 100 shares for $9 per share ($900), return the borrowed shares, and pocket the $100 as profit ($1,000 – $900 = $100), less any additional fees.
Alternatively, if the price rises to $11 per share, the investor has to buy back 100 shares for $11 per share. This totals $1,100, for a loss of $100 ($1,000 – $1,100 = -$100), on top of any additional fees.
Why Short a Stock?
There are several motivations for shorting a stock. In general, traders might short a stock when they believe that the security’s price will fall in the future. This might be due to several factors, such as an overall bearish outlook on the market, or specific concerns about a company’s financial health or prospects.
Some traders might also short a stock to hedge their portfolios by reducing exposure to potential losses in long positions. For example, if a trader is long a stock that they think will fall in value, they might short a similar stock to offset potential losses.
Shorting a stock can be a risky proposition regardless of strategy. If the stock price does not fall as expected, the trader will be forced to cover their position at a loss. As such, traders must be cautious when considering whether or not to short a stock.
How to Short a Stock
There are several steps involved in shorting a stock.
1. Set Up a Margin Account
First, you’ll need to set up a margin account with your brokerage. Margin accounts allow traders to borrow shares from a brokerage to sell them. They also enable traders to borrow the funds needed to take on larger positions in a short than they could with their own account balance.
2. Identify a Stock to Short
With a margin trading account funded and ready to go, investors typically target stocks they believe are overvalued or have weak fundamentals. These tend to be more likely to experience price declines. Some common indicators are declining earnings, negative media attention, or a downward trend in the stock’s price.
3. Place a Short Sell Order
After identifying a stock to short, it’s on to the execution phase. To do this, a trader places a short sell order through their brokerage account. The order instructs the broker to borrow shares from an investor or institution and sell them on the open market at the current price, on your behalf.
Traders can choose between a market order (sells the shares at the best available price) or a limit order (specifies the price at which you’re willing to sell).
4. Monitor Your Position
Short sales carry higher risks than other trades, which makes it vital to monitor the position closely and adjust their strategy as market conditions change. Potential gains and losses are amplified when margin is involved. Gains are limited by the difference between the strike and short sale price, and your risk of loss is unlimited.
Stop-loss orders and other stock orders can help manage risk by automatically closing a position if the stock moves against your position for a certain amount of time.
5. Close the Short Position
To close a short position, the trader must repurchase the same number of shares they borrowed. Ideally, they would buy the shares at a lower price than the original sale price. This is known as “buy to cover,” and it allows the trader to return the shares to the brokerage. The trader then realizes any profit or losses based on the price difference.
In rare cases, the lender may request that the trader return the shares they borrowed, but it’s far more likely for the trader to close their position at that point since the short would likely be losing money in this scenario. A short seller can hang onto their short position for as long as they can pay the required interest fees for borrowing stock and maintaining the margin amounts required by the brokerage firm.
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What Are The Risks and Rewards of Short Selling?
As noted, there can be some significant risks associated with short selling. But there can be potential rewards, too.
Risks of Short Selling
Selling a stock short involves significant risk — far surpassing the risk of “going long” on an investment. When holding a stock, there’s a limit to how low a stock can go, and investors can only lose as much as their initial investment.
If someone buys 10 shares of XYZ company at $10 per share, for example, and the share price goes to zero, they will lose $100. The price can’t go lower than zero, so someone can never lose more than what they had first invested.
However, when someone shorts a stock, they risk potential losses that are unlimited, as there is the potential for a stock’s price to rise indefinitely. If the price keeps going up, they will keep losing money.
Additionally, there are significant costs associated with shorting a stock. For one, the margin interest in a required margin account can add up over time if an investor keeps the position open for a while. Brokerage firms will charge interest on the borrowed shares, ranging from a few basis points to more than 100%, depending on how difficult the shares are to borrow. These costs can make shorting a stock prohibitively expensive.
Potential Benefits of Short Selling
While risky, shorting a stock could be profitable. Short selling may result in substantial gains during rapid price declines, though it also carries risk.
When investing during a recession, for example, sudden drops in the share prices of many stocks across many different industries can occur. While this might cause many investors’ portfolios to decline, others may be profiting because of their short positions.
Investors might choose to short a stock to hedge against their long positions. The term “hedge” is used to refer to an investment that protects against losses in another asset. So, in this case, an investor may put on a short position to hedge or offset a potential loss in a long position.
Short Selling Techniques and Best Practices
There are numerous short-selling strategies that investors might employ, and several of them are relatively straightforward, but require careful risk assessment.
For example, one technique that investors can use is to short sell a stock that is in a longer-term downtrend, but that has seen a short-term bounceback in value — it may continue that downtrend after a short time. Additionally, investors might enter a position (with proper risk management in place) when price trends are ambiguous. Investors can even try short selling while a stock is seeing an active decline. If that decline continues, investors could potentially capitalize on it, though other short-sellers could catch on, too.
What Happens in a Short Squeeze?
A short squeeze refers to the rapid flight of short sellers from a stock in order to limit losses — a situation that leads in a dramatic surge in the stock’s price.
Here’s how they typically occur: a sudden increase in the stock price causes investors to scramble to close their short positions by purchasing shares. This results in further gains in the stock, which in turn causes massive “covering” by other short sellers, bringing about a “squeeze.”
Famous cases include Volkswagen in 2008, which involved unusual circumstances related to Porsche’s increased stake in the German automaker, causing a short squeeze that briefly made Volkswagen the world’s most valuable stock by market cap.
In January 2021, the gains in GameStop (GME), a brick-and-mortar video-game retailer, were due to a massive short squeeze after retail investors piled into the stock, which hedge funds heavily shorted. Shares of movie-theater operator AMC Entertainment Holdings (AMC) and retailer Bed Bath & Beyond underwent similar experiences.
Is Shorting a Stock Wrong?
Short selling often raises ethical and moral concerns, particularly because it profits from the decline of a company’s share price. From a regulatory standpoint, short selling is legal and is recognized as a legitimate trading strategy. The practice can also aid with price discovery, which is how the market determines the fair value of a financial asset.
Concerns arise when short selling is associated with market manipulation, or when it is used to target companies for reasons outside of share valuation.
Legal and Ethical Considerations
Some investors have attempted to manipulate stock prices by spreading false bullish. Such tactics are considered market manipulation, and are illegal. Anyone caught attempting to manipulate markets might be subject to regulatory punishment by the Securities and Exchange Commission (SEC).
The ethical considerations about short selling focus on its potential to harm markets and the companies that list shares on them. Some critics argue that it can be used to spread false information about a company’s performance or long-term sustainability, especially during a short squeeze. Proponents suggest that short selling helps identify overvalued stocks, which can help make markets more efficient.
Alternatives to Shorting a Stock
Investors that want to capitalize on potential stock price declines, but without directly shorting them, can consider alternative strategies.
The first alternative to consider are put options. A put option is an options contract that gives the buyer the right to sell shares of an underlying asset at its strike price up until the option’s expiration date. The put option buyer pays a premium for the contract.
For example, imagine that an investor wants to short a stock whose shares are currently selling for $10. The investor believes the company is overvalued and the stock will soon head to $8 or lower.
The investor would buy a put option for the stock with a strike price of $10 and an expiration date of three months in the future. The investor pays a $1 premium for the put. If the stock falls under $10 during that time, the investor could exercise the contract to make money on the put option.
Suppose the stock falls below $8, as the put option investor forecasted. They could sell it for an increased premium to someone else. If an investor were to exercise the option, they’d profit from being able to sell shares for $10 that are worth $8, pocketing the $2 difference, minus the $1 premium, leaving them with $1. Since each option contract is usually worth 100 shares, the total profit would be $100.
Inverse ETFs
Inverse ETFs, or short ETFs, are another way to make a bearish trade. These investment vehicles use futures contracts to provide returns that are opposite the performance of an underlying index. Inverse ETFs assume either the broader markets, a particular asset class, or a market sector will go down in the short term.
For example: investors who believe a stock price will drop can buy a futures contract at a higher price, and if the share price does go down, the trader can buy the cheaper shares and then sell them at the higher price specified in the futures contract, thus realizing a profit.
An inverse ETF aims to provide opposite returns of a benchmark index uding derivatives such as futures or swaps, rather than directly shorting stocks. The biggest such ETFs are designed to provide the inverse returns of indexes like the Russell 2000 or the S&P 500. For example, if the S&P 500 goes down 1% on a given day, then a corresponding inverse ETF could be designed to go up 1% that day.
The Takeaway
Shorting a stock occurs when investors bet that the price of a specific stock or ETF will fall. Sophisticated investors with a bearish view of the market will often go short to profit from falling share prices. Short positions also help investors mitigate losses during widespread market downturns or hedge losses from another holding.
While shorting can be a useful investment tool, it’s also very risky. There is no limit to how high a stock can go, meaning there’s also no limit to the losses a short seller can potentially book. Trading on margin can multiply losses as well if the short sale does not go as the trader anticipates. In some cases, using an options trading strategy may accomplish similar results to going short.
If you’re an experienced trader and have the risk tolerance to try out trading on margin, consider enabling a SoFi margin account. With a SoFi margin account, experienced investors can take advantage of more investment opportunities, and potentially increase returns. That said, margin trading is a high-risk endeavor, and using margin loans can amplify losses as well as gains.
FAQ
What is a margin account and why do I need one for short selling?
A margin account is a type of brokerage account that allows investors to borrow money from their brokers to increase their purchasing power. A margin account is required in order to borrow the shares necessary to take a short position.
How can I manage the risks of short selling?
Thorough research and a robust strategy can help manage some of the risk involved in short selling. Traders may want to consider setting up and using stop-loss orders, which can exit a trader from their position if the stock gains value during a certain period of time. Lastly, it’s crucial to only invest as much as you are willing to lose. This can help right-size the role short selling has in your portfolio.
Can I short sell any stock?
No, there are restrictions on which stocks can be shorted, and they typically depend on the specific brokerage’s rules. For example, investors may not be able to short penny stocks, or short during specific market periods. There are also regulations about shorting that traders need to be aware of as well.
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