Short selling is an investment technique that generates profits when shares of a stock go down, rather than up. If you’re a fan of the movies, you might remember the 2015 film “The Big Short,” which focused on the success of some money managers betting that the housing market would go down.
But you don’t need to turn to the cinema for examples of successful short selling. In early 2021, you could get a master class just reading the daily financial news. In a phenomenon known as a “short squeeze,” those who bet against a stock are forced to “cover” their positions by buying shares; when lots of shorts cover at the same time, stocks can make dramatic runs higher.
In early 2021, stocks like Gamestop and AMC Entertainment were forced higher by short squeezes in spectacular fashion. For example, at one point, Gamestop rose 400% in a single week.
In most cases, shorting stocks is best left to the professionals. Here’s a look at how short selling works and why it’s generally not on the short list of things every new investor should know.
What Is Short Selling?
In Wall Street parlance, you “long” stock if you own it. You “short” stock if you borrow it and sell it. Because you now owe stock to the person who lent it to you, you are “short” the stock, just like you are “short” the rent if your landlord comes to collect and you don’t have enough money to pay him.
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How to Short Sell a Stock
The process of how to short stock is the same as how to buy stock, but in reverse. When you buy a stock, you sell your shares after they have gone up in value, generating a capital gain.
When short selling stocks, first you sell the shares, then you buy them back later. Although the order is reversed, the same principle holds true: if you buy your shares at a lower price than you sold them, you generate a capital gain. Here’s an overview of the process for making a short trade:
- Open a margin account, which is needed when buying a stock on margin or short selling a stock.
- Ask your broker if shares in the stock of your choice are available for short selling.
- Borrow the shares of stock.
- Sell the borrowed shares on the open market.
- At a time of your choosing, buy the shares back on the open market.
- Deliver those shares to the investor/firm that lent you the stock.
- Book your profit — or loss — on your tax return.
5 Reasons Why You Shouldn’t Short a Stock
Shorting a stock is a complicated process that can prove expensive to a novice investor. The following are just a few of the reasons why shorting a stock is an investment you might regret:
1. Your Loss Is Theoretically Unlimited
Examples of shorting a stock might help you put this practice into realistic terms. Imagine that you short 100 shares of a stock at $50 per share. Disregarding fees and commissions, you’ll net $5,000.
If you were to “long” the stock — meaning you purchased it outright — the most you could lose is the $5,000 you put in. However, if you are shorting the stock, at some point you’ll have to buy it back.
If the stock has rallied strongly, it might someday be trading at $175 per share. If you buy it back at that level, you’ll pay $17,500 — resulting in a loss of $12,500 — much larger than the $5,000 maximum loss from owning the stock. Since a stock could go to thousands of dollars per share — or theoretically, to nearly any price — your loss when shorting stocks is also theoretically unlimited.
2. Shorting Stocks Might Carry Extra Costs
When you borrow things from a financial services firm — including shares of stock — you’ll have to pay interest. You might also be charged a loan fee. Interest rates on margin loans can be high. Charles Schwab, for example, charges as much as 8.325%, as of May 10, 2021.
3. You Can’t Use the Money
When you short a stock, the sale proceeds must remain in your account to cover the cost of your future buyback of the stock. Additionally, Federal Reserve regulations require posting 50% of the cost of the trade to your account. This means if you short a stock that generates $10,000 in proceeds, you need to deposit an additional $5,000 into your account.
4. You Might Face a Margin Call
If you short a stock that goes up in value, you’ll have to deposit additional money into your account, known as maintenance margin. Securities regulators require a minimum 25% maintenance margin, but most financial services firms require 30%. This means if you short a stock that goes up to $10,000 in value, you’ll get what’s known as a “margin call” to deposit an additional $2,500 at least, and most likely $3,000 or $4,000.
5. You Could Be Forced to Buy Back
Although rare, if the firm or investor you borrow your stock from decides they want to sell it, they can call it back from you at any time, known as a “buy-in.” You’ll be forced to buy back the stock at the current market price so you could deliver the shares to the lender.
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Last updated: May 12, 2021