Shorting, also called short selling, is a way to bet against a stock.
It involves borrowing and selling shares, then buying them back later at a lower price and returning them while pocketing the difference.
If the stock goes down, the trader makes a profit, but there are several major risks involved.
Because of the various risks, short selling can lead to big losses and is considered much riskier than simply buying and holding stocks.
Most investors shouldn't be shorting, at least not without doing a lot of research and taking the proper precautions to reduce risk.
However, if you understand the risks involved but still want to short a stock, then this article explains how to do it.
How to short a stock: 6 steps
These instructions assume that you have a brokerage account that you can use to buy and sell stocks. If not, here is a guide on how to get one.
These are the six steps to sell a stock short:
- Log into your brokerage account or trading software.
- Select the ticker symbol of the stock you want to bet against.
- Enter a regular sell order to initiate the short position, and your broker will locate the shares to borrow automatically.
- After the stock goes down, you enter a buy order to buy the stock back.
- When you buy the stock back, you automatically return it to the lender and close the short position.
- If you buy the stock back at a lower price than you sold it at, then you pocket the difference and make a profit.
The process of shorting a stock is exactly like selling a stock that you already own. If you sell shares that you don't own, then your sell order initiates a short position, and the position will be shown in your portfolio with a minus in front of it.
For example, if you own 100 shares of Apple and then sell 100 shares of Apple, then your position will go to 0. But if you own 0 shares and then sell 100 shares, it will become a short position of -100. The process is identical.
When you sell a stock short, it actually increases your cash balance by the amount you sold the stock for. But you will need the cash later to buy back the stock and close the short position.
Keep in mind that the short-selling process may be slightly different depending on the brokerage. You also need a margin account to sell short, so you should contact your broker to make sure you have the proper permissions.
In addition, not all shares can be sold short. It depends on your broker being able to find shares for you to borrow, which is not always the case.
You can follow the same process for shorting many other types of securities, including ETFs and options.
What short selling is and how it works
Buying a stock is also known as taking a long position. A long position becomes profitable as the stock price goes up over time, or when the stock pays a dividend.
But short selling is different. It involves betting against a stock and profiting as it declines in price.
Here's how short selling works:
- A short seller borrows a stock, then sells it immediately on the open market and gets cash in return.
- After some time, the short seller buys the stock back using cash and returns it to the lender.
- If the stock declined in price in the meantime, the cash required to buy back the shares is less than the cash received from selling the shares.
- This means that the short seller can pocket the difference and make money.
Borrowing and returning the shares is easy because the broker handles it automatically on the back-end. All the short seller needs to do to short is to press the sell button in the trading software, then hit the buy button to close the position.
Shorting can be done as speculation to profit from declining prices, or it can be done for hedging purposes to reduce the downside risk from a long position.
Let's use a hypothetical example to explain how a successful short trade might play out in the real world.
Tesla stock recently increased in price by more than threefold despite no significant improvement in the company's financials. It increased from about $250 per share to over $900 per share in three months.
A smart trader could have seen this rapid price increase and realized that it was probably unsustainable. The trader decided to sell short one share of Tesla for $900. Now the cash balance in the trader's brokerage account increased by $900.
A month later, the stock had declined to $400, and the trader decided to cover the short position by buying the stock back for $400 in cash.
The trader got $900 in cash for selling the stock, then paid $400 in cash for buying it back. This leaves the trader with $500 ($900 - $400) in cash, which is the profit from the short sale.
A simple analogy for understanding short selling
It may be easier to understand short selling by considering the following analogy.
Let's imagine that you were to borrow your friend's car for a year. It is a 2-year old Toyota that is valued at $10,000.
However, instead of using your friend's car, you sell it to someone else for $10,000. You now have $10,000 in your pocket.
After a year, the car is a 3-year old Toyota with more miles on it than before, so it has declined in value. It used to be worth $10,000, but it is now worth only $8,000.
You buy the car back at the lower price of $8,000 and immediately return it to your friend. Your friend has gotten his car back, but you now have $2,000 of cash that you didn't have before.
This is exactly how short selling works, except that stock prices are much less predictable than the prices of used cars.
Shorting stocks costs money, sometimes a lot
These days, buying stocks (going long) is cheap.
Usually, the only fee you have to pay is broker commissions. Most good brokers charge very low commissions, and they are even free in many cases.
However, selling stocks short costs money. And the longer you stay in the trade, the more expensive it is.
These are some of the costs that you need to consider when shorting stocks:
- Commissions: When you sell short and then buy back the stock later, you will need to pay broker commissions. Same as with long positions, this usually isn't very expensive these days.
- Margin rate: You will need to pay margin interest to your broker, which is usually a few percentage points a year, depending on the broker.
- Stock borrowing fee: When shorting a stock, you need to pay a rate to the broker or lender for borrowing it. The rate is usually low but can become very high for heavily shorted stocks.
- Dividends: If you are short a stock that pays a dividend, then you will need to pay the dividend amount to the broker or investor you borrowed the stock from. The cash will be deducted automatically from your account.
Out of these, the stock borrowing fee is often the most significant. Heavily shorted stocks can be expensive to borrow, sometimes more than 100% per year.
Because of this, time is working against you when shorting. The longer you are short the stock, the more it needs to go down just to cover all the costs.
Short selling has several major risks
Short selling is incredibly risky, which is why it isn't recommended for most investors. Even professionals often lose a lot of money when shorting.
Here are some of the key risks to be aware of when selling stocks short.
The stock can go up
The biggest risk of shorting is that the stock can go up, sometimes by a lot.
If this happens, it will cost more to buy back the stock than the cash you received selling it short, so you end up losing money on the trade.
In fact, this is the natural movement of the stock market. It tends to go up over time, and most individual stocks follow the same trend as the overall market.
Importantly, the losses when shorting are theoretically unlimited. The max loss of a long position is 100% if the stock goes to zero, but stocks can theoretically go up an infinite amount.
If you had shorted Amazon stock at $400 in 2015 and stubbornly held on to the position, you would have been down 500% when it reached $2,000 back in 2018.
If you have a big short position in a stock that goes up a lot, then you can lose everything. And stocks sometimes go up without warning outside of market hours, so don't count on always being able to cut your losses easily.
For example, some news might get released overnight and cause the stock to go up a lot before the market opens. This happens all the time.
Your timing could be wrong
When shorting, timing is everything.
Not only are you paying the stock borrowing fees while you hold on to the position, but the stock could go also continue going up long before starting to decline.
For example, you could have been very smart to short bank stocks before the 2007-2009 recession.
But if you had started shorting too early, such as in 2005, then you could have lost a lot of money. You might even have been forced to close your position at a big loss before the trade finally started working out.
There is a popular saying in the investing community, attributed to economist John Maynard Keynes: "Markets can stay irrational longer than you can stay solvent."
When shorting, being too early is often the same as being wrong.
Margin calls can force you out of your position
If the short position goes so far in the wrong direction that you don't meet your margin requirements anymore, then you may be forced out of your position at a big loss due to a margin call.
Even if you are willing to hold the position for a long time and wait for it to become profitable, your broker may not be as patient.
The lender could want the shares back
It is possible that the investor you borrowed the shares from needs the shares for some reason and calls them back. Then you may be forced to cover your position, which could happen at a bad time.
Restrictions are often placed on short-selling
In some cases, restrictions are placed on short-selling during severe market turmoil. Short sales of specific stocks can even be banned temporarily.
Although you should be able to close your position just fine, these restrictions could cause the stock to go up, and you may need to close your position at a loss.
Short squeezes can happen in heavily shorted stocks
Stocks that are heavily shorted are vulnerable to a short squeeze, which can cause them to go up by many hundreds of percent in a short amount of time.
Shorting alternatives: other ways to profit from declining prices
There are several other ways to profit from falling prices that are also risky, but not quite as risky as short selling.
These trading methods have a max loss of 100%, unlike short selling, where the max loss is theoretically infinite.
Many traders prefer to bet against stocks using options contracts called put options. The put option gains value as the stock price goes down.
Unlike short selling, your maximum loss on a put option is 100%. It will go to zero if the stock doesn't drop below a certain price by the time the put option expires.
Exchange-traded funds (ETFs) are popular ways to invest passively in indexes of stocks. For example, millions of people invest in ETFs that track the S&P500.
However, there are also inverse ETFs that go up in price as the underlying indexes go down. The prices of these ETFs move inversely to the indexes they follow. If the index goes down by 1%, then the ETF goes up by 1%.
You can even find double-leveraged and triple-leveraged inverse ETFs that move 2X and 3X in the opposite direction as the index.
Inverse ETFs are also risky, especially leveraged inverse ETFs. The max loss is 100%.
Only go short if you truly know what you are doing
At the end of the day, short selling is a very risky trading method that should only be done by sophisticated investors.
If you are planning on going short, then you should do a lot of research first. Even then, you should probably keep your position size small and have a clear exit plan on when to cut your losses if the trade goes against you.
For example, you could set a buy-stop order at a 10-20% higher price than your entry. This will cause you to close the position automatically if it crosses that price.