Shorting A Stock: What Is Short Selling?
Scott Steinberg7-minute read
November 30, 2021
What is shorting a stock? Put simply, short selling refers to a type of transaction in which a seller borrows and sells shares of a stock that they believe will decrease in value – then hopes to later pay these shares back while pocketing the price difference. Here, we’ll take a closer look at how short selling works, how to short a stock, and what potential benefits and downsides you stand to encounter from shorting a stock in practice.
What Is Short Selling A Stock?
Short selling refers to the practice of short sellers or investors buying borrowed shares of stock for less money than they’re currently worth. Under the terms of a stock shorting agreement, the borrower agrees to return these shares to their original owner at a later date – hopefully for less money than they paid, allowing for a profit.
In other words, shorting a stock is a transaction in which an investor (the “short seller”) borrows shares of a company’s stock that they believe will decrease in value. The short seller essentially borrows these shares with the expectation to return them to the lender at a specific date and then immediately sells those shares to buyers willing to pay the current market price. When the stock price later drops in cost, the short seller then repurchases these shares in turn – effectively having bet that the value of the shares will have fallen and allowing them to buy and repay the shares at a lower cost than the initial asking price.
How Does Shorting A Stock Work?
As you might imagine, short trades can prove a highly risky investment strategy. When successful (meaning the stock or security’s value falls during the proposed time period), the investor gets to pocket the difference between the initial sale price and subsequent sale price. But if this strategy fails and the price of a stock goes up instead, investors may find themselves on the short end of the stick – and out of pocket a considerable difference, with no maximum cap on the money that they can lose. This scenario is known as a short squeeze. As opposed to a traditional “buy low, sell high” scenario, a stock short scenario instead adopts a “buy high, sell low” philosophy in practice.
In practice, shorting a stock works as follows:
- A short seller or investor borrows stocks or shares of a company that they don’t own, but that they believe will decrease in value, for a set time period.
- Short sellers then sell these shares to buyers willing to pay the current market price in turn.
- Short traders bet that stock or share prices will continue to drop in value before they have to return the borrowed shares.
- When the time period to borrow stock expires, short sellers then repurchase the shares of stock and return them to the original buyer – basically, hoping to purchase these shares at a lower price than that they’d initially sold for.
- The difference between the selling price and the rebuying price is the short seller’s potential profit.
Note that if an investor is said to have long positions in a stock, it means that the particular investor has already purchased and owns shares of these stocks. On the flip side, if the investor holds short positions, it means that they have borrowed and owe these stocks back to a lending party, and do not actually own these shares.
Shorting A Stock Example
Imagine that Taylor believes that the price of electric car maker Tesla’s (TSLA) stock is overvalued at $1,000 and is set to tumble.
She may elect to borrow 20 shares of TSLA from a lending broker, who then sells her these shares of stock at the current market price ($1,000), bringing in a total of $20,000.
If the price of TSLA stock suddenly falls to $800, Taylor can then buy back all of these shares at the new, lower price (for a total of $16,000), return the shares that she borrowed to her trading partner, and pocket a cool $4,000 ($20,000 – $16,000) in profit.
But if TSLA’s stock price unexpectedly rises to $1,100, she would lose $2,000 ($22,000 - $20,000) instead – and there’s no telling how much a stock may actually rise and fall despite the best predictions. As a result, potential downsides may be unlimited – a major concern in an age where stocks can experience rollercoaster-like levels of ups and downs.
Why Investors Sell Short Stock
Investors sell shorted stocks in hopes of capitalizing on a potential decline in the market to help protect their capital gains or reduce their capital losses. In essence, just as traditional stock traders make financial bets that hinge on stocks increasing in value, the practice of short selling allows investors to make bets that values will decline instead. For clarity’s sake, investors generally short stocks when they feel that a stock is noticeably overvalued and that market sentiment surrounding these shares is poised to decline.
Basically, investors aim to short stocks because it’s their hope that the price of the stock will decline and that by betting against the value of a stock increasing, they can turn a tidy profit. It’s a quick way to earn income by trading equities and creates a potential opportunity to benefit from the stock market, even when market prices are falling. However, while shorting a stock can prove lucrative, especially if done at scale, it’s also a highly risky bet – and one that won’t always work out in your favor.
The Rewards And Risks Of Short Selling
As with any stock market investment strategy, short selling comes with potential advantages and disadvantages. Note that it is not for the faint of heart.
Investors who engage in short selling are simply playing a different sort of economic theory: certain stocks will sink, not grow in value, and present future benefits to those who can spot these shares in advance. Upsides often include:
- Sizable profits: If you can correctly pick a sound prospect and accurately time a short stock sale, there are potentially significant sums of money to be earned from short selling.
- Hedging: Investors who’d like to play an investment strategy that hedges against dips in the economy and the value of certain stock market holdings often turn to short selling.
- Liquidity: As you can borrow and quickly sell shares of stock, short selling can also provide you with additional access to capital within a short timeframe.
Risks of short selling a stock are considerable, noting that there’s no telling if, when, or how much a stock price may rise or fall despite predictions, which can lead to costly mistakes. For example:
- Increases in stock value: If the value of a stock goes up instead of down, you can stand to lose large amounts of money as well.
- Unlimited potential losses and limited gains: Your profit potential on a stock that you buy traditionally is not capped, provided that the stock continues to rise in value, while the potential gains from a short sale are limited to the amount that you have shorted.
- Margin call: To engage in short selling, you need to hold a margin account with a broker. Your broker’s rules will require you to maintain a minimum amount in maintenance margin – and market fluctuations may require you to add more funds into your account.
As you might imagine, short selling isn’t for everyone, and electing to do so takes considerable risk tolerance.
Shorting A Stock FAQs
Several frequently asked questions (FAQs) tend to pop up surrounding shorting a stock. Answers to the most common can be found here.
How can short selling make money?
Investors make money from short selling by pocketing the difference in price between what borrowed shares are sold at and what they’re repurchased for at a later point in time. If you initially sell them for more than they’re worth at the time of repurchase, any profits generated from the short sale are yours to keep.
How much does it cost to short a stock?
That depends on your broker, interest rate, and how much stock you’re borrowing. Borrowing shares from a brokerage is a form of margin loan – and you’ll need a margin account to do it. You may need to agree to pay a certain interest rate on your outstanding debt. Likewise, you’ll need to maintain enough equity in your margin account to serve as collateral for this loan when executing and maintaining short positions, which can vary by brokerage.
Does shorting a stock bring the price down?
No – that’s up to market forces such as company financial performance, investor sentiment, and economic realities to determine. Unless you’re playing with hedge fund levels of investment capital, it takes the collective action of many investors to impact stock prices.
How long can I short a stock for?
A set period of time to be agreed upon with your broker. There’s no hard and fast time limit imposed by federal law.
How can I tell if my stock is being shorted?
Many stock monitoring and quote services can help you get a sense of how many shares have been sold short recently, and market exchanges often publish reports chronicling activity here.
What is a short squeeze?
A short squeeze occurs when a shorted stock’s price rises instead of declines – effectively putting the squeeze on those investors who’ve bet against it. A short squeeze tends to occur when the price of the stock rises rapidly, as the higher the stock price goes, the more that short sellers must purchase additional stock to cut their losses. Ultimately, short sellers are faced with the choice of deciding between continuing to pay interest on the borrowed shares or having to buy shares at a new, higher price.
Is shorting a stock an option for me?
That depends: Do you have the knowledge, insight, and experience to successfully play the market and make forward-looking predictions and stock calls? Are you comfortable with putting potentially large sums of capital at risk in speculative investments? While upsides to short selling can be high, downsides can be equally considerable. At the end of the day, if you have questions or concerns here, it pays to consult with a qualified financial professional.
The Bottom Line
Shorting a stock is a high-risk investment strategy that can often produce more losses than gains. Therefore, while it holds the potential to generate significant profits, it’s not recommended that you utilize this strategy unless you’re a skilled investor who is knowledgeable about the stock market.
Simply investing in the right stocks can often prove a more stable and lucrative endeavor for the average, everyday investor. To learn more about investing in stocks, and making your money work harder for you, be sure to browse our Learning Center.
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