What Is Shorting a Stock?

What Is Shorting a Stock?

What Is Shorting a Stock?
Reading Time: 5 mins

When trading securities, it’s possible to make money when the market moves up, down, or sideways. Betting on a move down seems strange, but thousands of retail investors are now rallying behind a common Wall Street practice—short selling—which is largely used by hedge fund managers. Although you may view short selling as betting on failure, you’d be surprised by how much you can profit from a decline in a stock. 

The outrageous stock gains and subsequent declines we witnessed in heavily shorted companies like GameStop and AMC have sparked investors’ interest in short selling. Given the degree of risk in shorting a stock, it’s not a strategy we would recommend to rookie investors. 

Wondering what shorting a stock is and how it works? Today, we’ll delve into what shorting stocks is, explain how it works, and reveal insider knowledge on why investors short sell. 

What Is Short Selling?

Short selling, or shorting a stock, is an investment strategy that lets you bet that the future price of a security will be lower than its current market price. When you short a stock, you’re simply selling the shares of a security you don’t own.  

As a trader, investor, or speculator, you borrow shares of a company that you believe will lose value by a certain date. Usually, you borrow these shares from a brokerage that currently holds a position in the stock in what’s called share lending. Remember, you can only borrow shares if you have a margin account. 

Now, with the borrowed shares, you proceed to the open market and sell them to a buyer or buyers who are willing to pay the current market price. At this point, you’re not only betting that the stock price will fall before you return the borrowed shares; you’re banking on a continued decline in the share price so that you can buy back the amount of shares you bought, or more, in order to return them to the lender broker. By buying back the shares at a lower market price, you’re essentially covering your position. You’ll only profit from short selling if you’re able to buy back your shares at a lower price. 

When trading stocks in the usual way—buying the dip and selling high—your initial investment is the maximum amount you can lose. With short selling, however, losses are mathematically unlimited since you stand to lose more the higher the stock price rises. Should the price continue rising, you may find yourself on the short end of the stick, and with theoretically unlimited losses, the stock experiences a short squeeze.  

Rarely will a brokerage ask you to return the shares you borrowed. Since your broker lender only charges interest on the shares you borrowed, you can hang on to your short position, provided you can offset the interest fees for borrowing and maintaining the margin account. 

How Short Selling Works

To bring more practicality to this strategy, let’s review a hypothetical example of how shorting a stock works. 

Let’s say you’ve identified that Stock A trading at a current market price of $100 will decline after the company releases its quarterly report in a month’s time. You proceed to borrow 1,000 shares from a brokerage and short sell them on the open market. Now you short 1,000 shares you do not own in the hope that the share price will go down. 

A month later, Stock A’s price falls to $85 per share, and you decide to close your short position. You buy back 1,000 shares of the stock from the open market at $85 per share and return them to your broker. You make a profit of $15 per share, which totals $15,000 for the entire transaction, not including interest and commissions. 

However, if the stock price rises to $107 and you decide to close your position, you’ll need to buy back the shares at the current market price. The result is a loss amounting to $7,000 for the entire short sale transaction, not forgetting the interest accrued on the margin account. 

Why Investors Short Sell

The short-selling strategy is more nuanced than simply betting on the decline of a stock price; that’s why it’s only recommended for experienced portfolio managers or investors. So why do investors short sell? 

  • Hedging. Investors use the short-selling strategy to hedge a long position with an offsetting short position, usually to protect their security against risk. They may employ this strategy when they’re anticipating a market downturn, for instance. To protect other long positions, you’d short sell a stock that you’re expecting to fall. If there’s a downturn, the short gains should cover the losses in your long positions. 
  • Speculating. Investors leverage the short-sell strategy when they believe a stock price will fall, and they can cover their sales by buying at a lower price. For example, you may research a stock, discover that it’s overvalued, and conclude that its price will fall. In this case, short selling lets you profit from selling when the stock is high and buying when the price drops. 

For more experienced investors, short selling is usually for a good cause, but there are still a few rules to play by. To facilitate a short sell:

  • You must have a margin account. Your broker will monitor your account closely to ensure that you can meet the minimum credit requirements for your short position. 
  • You must borrow shares from your broker. In some instances, you may incur fees when borrowing securities to short. 
  • Your brokerage can recall the loaned shares at any time. Usually, there are no rules governing the period of time you have to cover a short sale when returning the shares. Even so, you may still be subject to a potential buy-in on short notice, which may require you to cover your short sale immediately. 

The Risks of Shorting Stocks

Short selling stocks carries significant risk, far surpassing what you’d risk by going long on your investment. When you buy and hold, there’s usually a limit to how low your portfolio can go. You only stand to lose as much as your initial investment. A security’s price can never go below zero, so you’ll never lose more than you invested initially. 

When you short a stock, there’s a risk of infinite losses, since there’s no upper limit to the price your stock can reach. As long as the stock price keeps rising, you’ll keep losing money. 

If you’re looking to short sell stocks, don’t assume that you’ll always have a guarantee that you can repurchase the shares whenever you want, and at your desired price. Stocks are marred by volatility that may change the game altogether. 

What Is a Short Squeeze?

A short squeeze occurs when short sellers try to close their positions rapidly in an attempt to limit their losses, which leads to a dramatic surge in the stock price. But how exactly does a short squeeze occur?

The aim of shorting stocks is to amass profits from a stock whose value continues to decline. Going short is just as beneficial as it is risky. One huge risk is that when bullish news pushes the stock prices even higher, short sellers all scamper for the exits at once. The rapid flight of sellers scrambling to buy back and cover any imminent losses may trigger an upward momentum that causes the stock price to rise even higher. 

Why are short squeezes so dangerous? Look at it this way: when you purchase a security, the worst outcome is its price dropping to zero. However, the upside is fundamentally unlimited. If a stock peddles a growth narrative and there are enough believers behind the rally, the share price may soar to levels that the traditional fundamental metrics deem outrageous.

The most recent case of a short squeeze occurred in January 2021, when video game retailer GameStop achieved its all-time high after retail investors rallied behind a stock that was heavily shorted by hedge funds

Is Short Selling Good or Bad Practice?

Despite being a favourite strategy among hedge funds, short selling isn’t without controversy. Shorting is frowned upon by many who fear that unscrupulous investors may spread malicious rumors about a company to influence the share price. Remember though: the trickery can still go both ways! There might also be investors who manipulate the rise of a stock price by spreading false bullish rumors. These are foul tactics meant to manipulate the market, and they are illegal. 

Shorting can be a strategy to hedge investing risks. For instance, shorting to protect a long position can help you minimize your losses, albeit at the expense of their gains. 

Conclusion

Shorting a stock simply means betting that the price of a security will fall, and is often a trademark strategy for people who are bearish on a specific company. Short selling may help investors cover losses during market downturns or hedge losses from another portion of their portfolios.  

On the flip side, shorting comes with very high risks attached, because there’s no limit to the amount of losses you can take on. The ballistic rise in a stock price may trigger a short squeeze as investors rush to exit their positions, which can result in painful losses. 

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