Short selling, the subject of the popular film The Big Short has received a lot of media attention recently. While some might present short selling as an investing “hack” or a way to make a lot of money quickly, it's worth it to take the time to explore the details of this risky investment strategy.
Essentially, short selling is when you borrow stocks to sell them at a high price and then repurchase them later at a lower price. You make money from the difference between the high selling price and what you hope will be a lower price when you repurchase the stock. When you short sell a security, you bet that the security price will fall.
Short selling is considered an advanced trading technique because it’s risky. A high-level way to think about the risk of short selling is that the lowest price a security can fall to is zero, but there is no limit to how high the price can go.
While short selling can crush a company’s share price, it's not always done with malicious intent. There are legitimate uses for short selling. This article will discuss short selling and its utility in the financial markets.
How Is Short Selling Different from Regular Investing?
When you invest in a security, you expect it to increase in price over time, and you make money from selling at that higher price. In contrast, when you short sell a stock, you expect it to decrease in price. You must also have a margin account to cover any potential losses because when you short sell a stock, you are effectively selling an asset that you do not own.
Why Is Short Selling Controversial?
This is a controversial investment strategy because it can drive a company’s share price down when enough investors short sell — especially if investors start panicking.
During the pandemic, short selling became especially controversial when retail investors rallied around stocks with heavy short interest, such as GameStop (NYSE: GME). Citron Research, an investment firm specializing in short sells, sparked outrage because it was a short seller of GameStop stock. As a result, Citron Research stopped publishing short selling research reports altogether.
How to Short a Stock
There are typically two ways to short a stock:
- Short selling — You borrow shares from your broker, and you immediately sell the shares. If the share price drops, you can repurchase the shares back at a lower price and return them to the brokerage.
- Buying a put option — Put options give you the right to sell a stock at a specific price, but not the obligation. Your maximum loss is the premium you paid for the put option. Your put option contact will typically increase in value as the stock price decreases, all other factors considered. In this situation, you still bet on the stock price's decline, but with less risk involved.
But what happens if the stock price goes up? A stock that increases in value is the last thing you want when you short a stock. A stock price that continues to rise may result in a “short squeeze” and subsequent losses.
If you short sell a stock, your potential losses are technically infinite because there is no limit on how high a stock can go. If the stock price is significantly higher than when you did the short, continuing to hold it may trigger a margin call, meaning that you have to increase your collateral to maintain your position.
In contrast, if you short buy a put option, you can only lose the premium you paid: Your losses are limited.
Why Is a Margin Account Important in Short Selling?
As mentioned previously, you need to borrow shares from your broker to sell. However, brokers only lend to approved margin accounts. So, before you short sell a stock, you must be approved for a margin account.
The broker typically gets shares from another margin account, their inventory, or even another broker. (You don’t have to borrow shares from your broker if you buy a put option to short a stock.)
Remember that the longer you maintain your short position, the more interest you will pay on your borrowed shares, thus reducing profits on a successful short position.
Why Do Investors Short Stock?
Investors short stock because they believe that the share value will decrease. Typically, short sellers believe the current market price of a stock is overvalued and will decline with time or a catalyst.
Sometimes a particular company’s stock will receive a high level of interest, and an influx of share purchases will drive the price up. Investors develop a fear of missing out, so they buy the shares. The company’s share price may increase significantly above its fair value. Short sellers see this as an opportunity to capitalize on what they see as an inflated share price.
An Example of Shorting Stock
Let’s review an example. You believe that XYZ company is overvalued and its share price will decline in the next couple of months, so you decide to short sell it.
First, you borrow 100 shares of XYZ stock, which is currently trading at $100 per share, and sell it immediately. Now you are “short” 100 shares of stock because you effectively sold XYZ stock even though you don’t own any.
Three weeks pass, and XYZ’s share price drops to $70 due to a poor earnings report. You decide that you don’t want to take the risk that the price might recover in the coming weeks, so you decide to close your short position. This means that you purchase 100 shares of XYZ at $70 on the open market to replace the 100 shares that you borrowed from your broker.
In the end, you’ve made a profit of $3,000 from this short. You borrowed and sold 100 shares of XYZ at $100 ($10,000 total) and then bought 100 shares of XYZ stock at $70 ($7,000), pocketing the difference ($3,000). (Note: Your actual profit will be less than a total of $3,000 due to commissions and interest in the margin account.)
Alternatively, suppose XYZ’s earnings report was positive, and its share price rose to $130 a share. You get nervous that XYZ will continue to increase, so you opt to close your position. Your loss will be $3,000 because you had to buy back the shares at the higher price of $130.
How Do You Profit from a Falling Company Without Shorting the Stock?
If you feel short selling goes against your morals, here are some alternative ways to invest in a company’s decline:
Selling Put Options
If you think that the company would actually be a good investment at a specific price below the current market value, you can sell put options at a strike price lower than the company’s current value. Selling a put option obligates you to buy the stock at the strike price, so be sure not to sell more put options than you are comfortable buying.
When one company fails, its competitors sometimes benefit from the decline. For example, if a company’s stock falls because it is losing market share to a competitor, you can purchase its shares and indirectly benefit from its decline.
What are the Risks of Short Selling?
If short sellers incorrectly estimate a decline in stock share price, the consequences can be devastating. Below are some risks associated with short selling:
- Margin call — Small upswings in share price are manageable unless the value of your margin account falls below your broker’s required threshold to maintain that position. In this case, a margin call may occur, which means you are forced to deposit additional funds, sell assets, or close your short position.
- Staying overvalued — Even if a particular stock is overvalued, that doesn’t mean it’ll drop to its intrinsic value. Meanwhile, you will still be paying fees in your short position, and you'll have to worry about a margin call. Remember the famous saying, “The market can remain irrational longer than you can remain solvent.”
- Unlimited loss potential — As mentioned, if the share price of a stock continues to rise and you refuse to close your position, the potential losses you face as a short seller are unlimited.
Due to significant risks, short selling is considered an advanced strategy recommended only for investors with a high-risk tolerance.
Is Short Selling a Stock a Good Idea?
Short selling is an important tool for financial markets and does provide some benefits. Theoretically, short selling provides additional liquidity in price discovery improvement in bid-ask spreads. It is a mechanism where market participants can protect their investments, especially in an overheated bull market.
Short selling can make your portfolio less risky and more resilient to a market crash. For example, if you feel the market is overvalued, you can buy a put option on the major indices to protect your portfolio from a crash. Assuming a crash does occur, your profit from the put option will offset some of the losses from your long position.
The Bottom Line: Should You Short Sell?
Although it's a controversial strategy, short selling has its place in financial markets. It provides the market with liquidity and better price discovery. Short selling can also be used to protect your long investment portfolio.
However, short selling is very risky, especially since you must borrow shares to sell. Furthermore, when you short sell you have to pay fees, your losses are unlimited, and you run the risk of a margin call. If you're just getting started with investing, we recommend choosing stocks or funds that you believe will go up in value, not down.
It you're looking to invest traditionally, the good news is that most of the top stock brokers today provide commission-free stock and ETF trading. But if you're planning to short sell, you'll also want to pay attention to the margin rates that a broker charges. You can start comparing stock brokers here.
Disclaimer: The content presented is for informational purposes only and does not constitute financial, investment, tax, legal, or professional advice. If any securities were mentioned in the content, the author may hold positions in the mentioned securities. The content is provided ‘as is’ without any representations or warranties, express or implied.