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Short selling means investing in a stock in such a manner that you will profit if its price drops. It is the opposite of the traditional long position, which means you'll make money if the stock price rises. The difference between short sellers' buy price and the sell price is their profit. While on paper it may come off as a simple concept, short-selling stocks is a very advanced investment strategy best left to veteran traders and investors like hedge funds.
Once a short position is opened, and if things go awry, you could lose all of your initial investment. Not only that, there's a likelihood you may end up owing your brokerage money because there's no ceiling to the price of the stock; it can continue to rise indefinitely. As a result, unlimited losses can occur. On the flip side, however, your profit cannot exceed 100% because a share price can't fall below zero dollars. In fact, after borrowing costs and margin interest, profits are generally under 100%.
Related: How to Short Sell Stock
In this article
How does short-selling work?
In order to short a stock, you’ll need a margin account with a brokerage. This gives you access to borrowed stock. Remember: you don't own shares used in a short sale; they're loaned to you by brokerages. In stock market jargon, this is called a margin loan, and you'll be paying interest on the outstanding debt. And with these borrowed shares comes collateral you'll have to put up, which could be cash or stock equity.
Related: Best Brokerages for Beginners, 2022
Once these conditions are satisfied, you will be able to put in a sell order in your brokerage account. Remember, you're selling these loaned shares in the open market in the hopes that the price will fall. Once that happens, you buy back these shares, return them to the brokerage, and pocket the difference as profit.
Here's an example: You borrow 100 shares of a company, then sell them for $10 each, generating $1,000. The price then drops to $4 per share, so you repurchase these 100 shares at the lower price of $400, return them to the broker and make $600, minus any commissions and fees.
In addition to equities, exchange-traded funds (ETFs) can be shorted as well because they trade on a stock exchange. You can't take a short position in mutual funds though.
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Risks associated with short selling
Limitless losses
You're shorting a stock, and if the price falls, you make money. But what happens when the stock price rises in the open market? That's where things get dicey.
Let's look at the same example: You borrow 100 shares of a company and sell them for $10 each, generating $1,000. But the price rallies to $40 per share. Remember, these shares are borrowed and have to be returned to the broker. So you repurchase them for $4,000, that's $3,000 more than what you bought them for.
Theoretically, this can go on indefinitely. Sure, you can wait for the price to drop, but you're accruing interest on the borrowed shares.
Margin calls
A margin call is triggered when the value of the collateral in your margin account drops below the minimum requirement. As a result, you'll be immediately required to pump more cash or securities to meet the minimum value. In the event you fail to meet the margin call, the broker may liquidate your position to meet margin requirements.
Short squeeze
When a heavily shorted stock sees its price appreciate, short-sellers scramble to limit their losses and close out positions. As a result, they put in buy orders, accelerating, even more, the shorted stock's price. Every buy order sends the price higher, forcing other short sellers to purchase the stock. This is called a short squeeze. Because of the stock price's rapid rise, other investors also start buying the security.
One example of a short squeeze is video game retailer GameStop, which saw its stock price soar more than 1,000% in January 2021 after retail investors caused a short squeeze in stocks of struggling companies with high short interest.
High costs
Margin trading is an expensive business. You'll be on the hook for margin interest due on the loan made to you by the broker, and there are stock borrowing costs to consider. As a short seller, you will also be responsible for making dividend payments on the shorted stock to your brokerage. If the shorted company undertakes share splits or spin-offs, you will have to make these payments as well.
Market behavior
The stock market has an upward bias, and a shorted stock's valuation can pop for any reason. Markets fluctuate over the short term, but in the long run, they always increase.
Related: How to Borrow a Stock to Short Sell
Types of short selling
Covered shorts
When an investor borrows securities from a broker to potentially short sell, it is called a covered short. As noted, it is highly risky with potentially unlimited losses. Costs also tend to run high and you're responsible for paying margin interest and dividends.
Naked shorts
While covered shorts involve shares of stock borrowed from a broker, naked short is selling shares you don't possess.
For example, an investor sells short 1,000 shares even though they have not yet been approved for margin trading, and as a result, cannot borrow shares from their broker yet. As with covered shorts, the investor here is also betting that the price will fall. But what happens when the price falls and the investor now has to deliver shares they do not yet possess to the buyer? When the investor fails to meet the three-day time limit to deliver the shares to the buyer, it is known as a "failure to deliver."
Naked shorting can affect the liquidity of a particular security within the marketplace.
Synthetic short
This strategy isn't exactly shorting (that's why there's a "synthetic"), but the risk-reward profile is nearly identical. Here's how it works: you buy put options and sell call options in a stock simultaneously at the same strike price i.e. the price at which these options can be exercised. This replicates an actual short position in a stock. Futures and options are both examples of derivatives.
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What regulators think
Naked shorting was made illegal by the U.S. Securities and Exchange Commission in the wake of the 2008-2009 market volatility. But due to loopholes, it continues to happen and is mostly done only by options market makers.
The U.S. Department of Justice late last year reportedly launched a criminal probe into short selling, and specifically, the relationship between hedge funds that short sell and market research firms that publish negative reports on certain companies, Bloomberg News reported. Since then, the department has issued subpoenas to several funds. The SEC is also a part of the investigation.
Pros and cons
Pros
- Potential to make hefty gains.
- Short selling can be used to hedge your portfolio.
- You don't need a lot of money to begin shorting stocks.
Cons
- Advanced trading strategy not suited for novice traders.
- Potentially limitless losses.
- Markets have an upward bias, which doesn't bode too well for short selling.
FAQs
Is short selling risky?
Short selling has a high risk/reward ratio. It can offer big profits, but losses can rise rapidly.
How much profit can I make if a shorted stock's price falls?
The maximum profit you can theoretically make is 100%. However, after taking into account borrowing costs and margin interest, it will likely be below 100%. But keep in mind that losses can be unlimited.
Can I short ETFs?
Yes, because exchange-traded funds trade on an exchange, they can be shorted.
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The bottom line
Short-sellers make money by wagering that a particular stock price will fall. While it may sound like a simple concept, relatively few investors use this trading strategy. Betting against the stock market can be lucrative but it carries big risks. You may have to immediately meet margins calls and there's a likelihood of not only losing your money but owing more than what you invested. It's also currently the focus of an expansive investigation by the U.S. Justice Department.
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Writer
Jasir Jawaid is Joy Wallet's Assistant Editor. He has more than 13 years of experience as a journalist covering Wall Street, equities, financial policy and regulation, and cryptocurrency and blockchain.
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