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Shorting a Stock Defined and How Short Selling Works

By Brian Nibley · September 30, 2022 · 9 minute read

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Shorting a Stock Defined and How Short Selling Works

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, hope to buy them back at a lower price, and pocket the difference as profit. This strategy is popular among savvy, risk-tolerant investors with a knack for market research and predicting trends.

Short selling is one of the strategies that make it possible to make money in the market no matter how it moves — up, down, or sideways. 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 bolster their financial portfolios.

What Is Shorting a Stock?

Shorting a stock is an investment strategy where an investor borrows shares of the stock from an investment broker and sells the shares, hoping to repurchase them later at a lower price and return the shares to the broker. The price difference is the investor’s profit.

Shorting a stock is a way for investors to bet that a particular stock’s future share price will be lower than its current price. It’s the opposite of going long 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 found a company that they think is overvalued, so its share price is likely to decline. They borrow 100 shares of stock in company A from their brokerage and sell the shares for $10 per share for a total of $1,000 (plus any applicable brokerage fees).

In scenario A, the investor made a spot-on prediction, and the price fell to $9 per share. The investor can buy back 100 shares for $9 per share for $900, return the borrowed shares, and pocket the leftover $100 as profit ($1,000 – $900 = $100).

In scenario B, the investor misses the mark, and the price rises to $11 per share. Now the investor has to buy back 100 shares for $11 per share for a total of $1,100, for a loss of $100 ($1,000 – $1,100 = -$100).

Why Short a Stock?

There are various reasons why traders might choose to short 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. 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.

Whatever the reason, shorting a stock can be a risky proposition. 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.

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How to Short a Stock

Before you can short a stock, you will need to set up a margin account with your broker. Margin accounts are brokerage accounts that allow investors to borrow money or shares to make trades.

To short a stock, you will place a sell order for the number of shares you want to short. Your brokerage will often lend you the shares — a practice known as share lending — and allow you to complete the sale on the open market to another investor.

Ideally, when the stock price drops, you will buy back the same number of shares you borrowed, pocketing the difference between the sale and purchase costs, and returning the borrowed shares to the brokerage firm.

However, if the share price increases, you will have to buy the same shares for a higher price, potentially resulting in substantial losses,

In rare cases, the lender may request that you return the shares you borrowed, but it’s far more likely that you will close your position because the short is losing money. 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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Potential Risks and Benefits of Short Selling

Potential Risks

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 infinite losses because there is no upward limit on a stock’s share price. 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. Also, a brokerage firm will charge interest on the borrowed shares, ranging from a few basis points to over 100%, depending on how difficult the shares are to borrow. These costs can make shorting a stock prohibitively expensive.

Potential Benefits

While risky, shorting a stock could be profitable. It’s possible to make a lot of money in a short period of time, as stocks sometimes experience rapid, steep declines.

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.

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 to 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, after Porsche increased its stake in the German automaker, causing a short squeeze that briefly made Volkswagen the world’s most valuable stock by market cap.

More recently, 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 (BBBY) underwent similar experiences.

Is Shorting a Stock Wrong?

The practice of short selling is not without controversy. Shorting may have received a bad rap by being associated with the fear that shady investors will spread malicious rumors about a company to influence its share price.

But this kind of trickery can go both ways. There have also been investors who sought to manipulate the price of a stock upward by spreading bullish rumors that turned out to be false. Such tactics are considered market manipulation, and it is illegal. Anyone caught attempting to manipulate markets might be subject to regulatory punishment by the Securities and Exchange Commission (SEC).

Shorting can be a way of handling investing risks. For instance, shorting to hedge a position can be a type of risk management that helps investors minimize their losses, although doing so will also cap their gains.

Alternatives to Shorting a Stock

Shorting a stock is one of the several ways investors can bet on an asset’s price decline.

Put Options

If a brokerage account allows investors to trade options, buying a put option on a stock may allow the buyer to profit when it declines in price.

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 that we’ll call ABC company. Shares of ABC are currently selling for $10. The investor believes the company is overvalued and the stock will soon head to $8 or lower.

So, they buy a put option for ABC 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 ABC stock falls under $10 during that time, this option holder could exercise the contract to make money on the put option.

Suppose the stock falls below $8, as the put option buyer 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.

Buying put options is just one of the several options trading strategies investors can utilize if they have a bearish outlook on a stock. Options trading strategies can be profitable, but they are risky. Trading them requires more knowledge than trading stocks or exchange-traded funds (ETFs).

💡 For beginners: Options Trading 101: An Introduction to Stock Options

Inverse ETFs

Inverse ETFs are another way to make a bearish trade. These investment vehicles aim to provide returns that are opposite the performance of an underlying index. Investors can buy inverse ETF shares just like ordinary stock.

Investors must understand that inverse ETFs are designed to be held and traded during a single trading day. Kept for longer, inverse ETFs may not achieve the exact -1x return of the underlying index. That’s because of how returns get compounded.

Let’s look at the S&P 500 Index and a hypothetical inverse ETF that tracks it. The S&P 500 is at 2,000 on a given day, while the inverse ETF is trading at $20 a share. If the S&P 400 Index falls 1%, its new level would be 1,980. Meanwhile, the inverse ETF’s price would rise to $20.20 since it’s supposed to move in the opposite direction of the S&P 500.

If the S&P 500 rose 2% the next day, however, the index would climb to 2,019.60. The index’s total gain over the two days would be 0.98%. Meanwhile, prices of the inverse ETF would fall to about $19.796 — so a loss of -1.02% over two days.

While the difference between 0.98% and -1.02% appears small, such discrepancies can add up over time, causing the inverse ETF to deliver returns that aren’t the mirror opposite of its underlying index. Therefore, investors should not assume that just because a market falls 5% in a week, its corresponding inverse ETF will rise 5% in that same period.

The Takeaway

Shorting a stock is 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 use short sales 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. That’s because there’s no limit to how high a stock can go, meaning there’s also no limit to the losses a short seller can potentially book. Add to that the risk of a short squeeze — when there’s a massive rush by bearish investors to exit their short positions — and it’s fair to say that shorting can lead to painful losses.

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FAQ

What is naked short selling, and why is it illegal?

Naked short selling is a type of short selling where the seller does not have the borrowed securities in their possession at the time of the sale. This practice is illegal because it creates a potential for manipulation and fraud.

Why do short sellers have to borrow shares?

When a trader wants to sell a stock short, they must first borrow it from somebody else. They have to borrow shares because when you sell something, you have to have it to sell. The trader then hopes to repurchase the stock at a lower price so they can return the shares to the person they borrowed them from and pocket the difference.

Can I sell short in my brokerage account?

Many brokerages allow short selling in a regular account, but some require the investor to have a margin account. Your broker can tell you what kind of account you have and the requirements for short selling.

How is short selling different from regular investing?

Short selling is selling a borrowed security and hoping to repurchase it at a lower price to realize a profit. With regular investing, the investor buys the security and hopes to sell it at a higher price.

What is the opposite of shorting a stock?

The opposite of shorting a stock would be going long on a stock, meaning that the investor would purchase shares of the stock with the hope that the stock price would increase so that they could then sell the shares at a higher price and profit from the difference.


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