Short selling is an investment technique that generates profits when shares of a stock go down rather than up. In most cases, shorting stocks is best left to the professionals. In fact, it’s mostly institutional investors, such as hedge funds, that trade this way, according to Investor’s Business Daily.
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?
Short selling involves trading borrowed stock — more specifically, stock the investor believes will decline in value. If the strategy goes according to plan, they’ll sell the borrowed stock, replace it by buying it back at a lower price, and keep any profit left after returning the borrowed shares.
Example of How Short Selling a Stock Works
Say you identify a stock trading for $100 per share that you think will decline in value. You borrow 25 shares and sell them for $100 each, for a total sale of $2,500.
When the price drops to $50 per share, you buy 25 shares to repay the loan. The $1,250 left over, less interest due to the lender, is your profit.
Before you can short a stock, you have to open a margin account with a stock brokerage. The margin account allows you to borrow from the brokerage and serves as collateral for the loan. In the case of a short sale, the shares you borrow are loaned to you in this account from the brokerage’s own inventory or from the margin accounts of other investors. The loan bears interest, just like a loan you’d get from a bank.
How To Short a Stock
The process of how to short a stock is the same as how to buy stock, but in reverse. When you take a long position, you buy a stock and later sell your shares after they have gone up in value, generating a capital gain.
When short selling stocks, you start by selling the shares borrowed through the margin account. 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.
How To Short a Stock: Step-by-Step Guide
Here’s an overview of the best way to short a stock:
- Open a margin account through a brokerage.
- Add sufficient funds — you must have at least 150% of the share price.
- Ask your broker if shares in the stock of your choice are available for short selling.
- Borrow the shares of stock by entering a short-sale order in your margin account. This is called entering a position.
- Set a market price at which to sell the stock.
- Sell the borrowed shares on the open market. This is called closing a position.
- At a time of your choosing, buy the shares back on the open market. Setting a buy-stop order lets you specify the most you’re willing to pay, thereby limiting potential losses.
- Deliver those shares to the investor or firm that lent you the stock along with accrued interest.
- Book your profit — or loss — on your tax return.
Why Short Sell a Stock?
Short selling is a very risky strategy. But under the right circumstances, it can generate large returns for experienced investors. Here are the circumstances that might prompt an investor to sell short:
- Confidence that the stock will fall.
- To offset the risk of a decline in shares you already own.
- To potentially profit from a company’s hardship.
- In certain circumstances, to take a tax deduction on the interest you pay to borrow the shares.
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 cons that investors need to consider:
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 more, 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 13.325% as of May 6, 2023.
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.
Lessons Learned From the Meme Stock Craze
If you’re a fan of the movies, you might remember the 2015 film “The Big Short.” This film 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 short selling. In early 2021, you could get a master class just by reading the daily financial news about meme stocks such as GameStop and AMC Entertainment.
Investors who bet against the stocks faced “margin calls” from their brokerages. The calls forced them to “cover” their positions. This meant depositing funds into their margin accounts or closing their positions by purchasing stock. The volume of short sellers covering their positions at the same time drove share prices up — at one point, GameStop rose 400% in a single week.
This surge created a phenomenon called a “short squeeze” — literally “squeezing” out short sellers. It triggered margin calls, where the broker requires the investor to add funds to their account to cover losses. Brokerages also recalled borrowed shares from some investors. Both scenarios can result in devastating losses for the investor.
Important To Know
The lesson here is that the effects of short selling on a stock price are highly unpredictable. What’s more, investors use borrowed funds in the transaction and risk margin calls and share recalls. As a result, the potential losses are far greater than those of a long position, where the most you can lose is the price you paid for your shares.
Short selling is a technique that can provide large profits but it comes with a lot of risk. This method should only be used by experienced investors who understand the full spectrum of risks involved.
FAQHere are the answers to some of the most frequently asked questions regarding short selling.
- How much money do you need to short a stock?
- To short a stock you should have at least 150% of the share price.
- What are the pros and cons of shorting a stock?
- A pro to shorting a stock is the potential to make money, a lot of money in some cases.
- The cons to shorting stocks would be the risk involved. You could face a large loss of money and fees.
Daria Uhlig contributed to the reporting for this article.