Short Selling: What You Need To Know About Shorting Stocks

The movie The Big Short was possibly the first time short selling caught widespread attention in modern history, but you need a lot more than the basic explanations offered by the movie if you want to get into short selling yourself.

Shorting stocks is both a potentially lucrative investment strategy and a controversial one. Short sellers are often infamous, and short selling comes with many risks that investors usually want to avoid.

But, once you know how to short a stock, and when shorting a stock is a reasonable option, short selling can be an important part of your portfolio.

First, let’s get an overview of short selling and how shorting a stock works. We’ll explain shorting stocks, how you can short sell stocks, and what short selling does in the market. We’ll also provide some examples of short selling and talk about why shorting stocks can be a controversial decision.

If you want to learn what short selling is, how it works, and the pros and cons of shorting, you’re in the right place.

What Is Short Selling?

At the most basic level, short selling is speculating that a particular stock’s price will decline. To short a stock is to say that you think that stock is overvalued and that the value will, at some point, decline.

Assuming your shorted stock declines in price, you can profit from that decline.

However, the decision to short a stock is a complex one and often takes an in-depth evaluation of the stock’s value, company performance, and financial patterns that might not be immediately obvious when you first look at stock options.

That means that short selling is generally considered an advanced investment strategy that’s not suitable for beginners. Shorting stocks isn’t something all experienced investors do since knowing how to short stocks is a different skill than knowing which stocks to buy or sell.

Only experienced investors with a good eye for evaluating company performance typically become short sellers, so you should be prepared for a lot of work if you want to start short selling yourself.

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How Short Selling Works

Let’s get into a little more detail about how short selling works. To short a stock, investors first ‘borrow’ the stock from a dealer and sell it. By shorting the stock, they are counting on being able to repurchase the stock for less than they borrowed it, turning a profit when they return that stock to the original broker.

Before short sellers can buy or borrow a stock, they must have a margin account. The short sellers need to pay interest on the value of the stock while the deal is open and must maintain the minimum balance set by the Federal Reserve, the maintenance margin, for however long the deal is open.

If the short seller’s margin account falls below the maintenance margin, they need to provide additional funding to meet the maintenance margin, or the broker can sell the position.

All of that means that shorting a stock can be incredibly risky and expensive. The maintenance margin and interest required for the short can go up if the stock’s price increases, so miscalculations come with significant potential risks.

In some cases, short sellers may be forced to repurchase the stock and close the short before making a profit if share prices go up too much or if it takes too long for the stock’s value to decrease.

That means that shorting a stock isn’t just a matter of predicting that a stock’s value will go down but also predicting when that stock’s value will go down.

If you saw The Big Short, you saw this in action as several of the movie’s short sellers sweated over housing price inflation and struggled to understand why CDOs were maintaining value when they shouldn’t have.

The short sellers in The Big Short were worried not simply because the economy wasn’t working correctly. They were also concerned because their short positions continued to get more expensive so long as housing prices and housing CDOs remained artificially high.

Why Would You Short A Stock?

Given all of the risks of short selling, many people are left wondering why anyone would bother with shorting a stock in the first place. There are many other, less risky investment strategies out there; what draws people to shorting and turns them into short sellers?

There are a few reasons why investors might consider shorting or going short. However, it’s worth emphasizing that even with these advantages, new investors usually shouldn’t short until they have more market experience and are better at evaluating stocks.

A true short seller might short stocks because they see an opportunity to turn a quick profit, for instance. Shorts tend to be better in short-term positions because stock values, when they are going down, often go down faster than they appreciate or gain value.

Short sellers who are primarily short may also choose to short a stock because they see reasons why a stock is overpriced and expect a market correction. In some cases, short sellers might decide it’s worth holding a short position longer to maximize profits or as a strategy to expose overvalued stocks.

Hedge funds may also choose to short certain stocks, but they don’t have the same motivations in most cases. Rather than looking to directly profit off a short position like short sellers, hedgers usually short stocks to hedge their bets and minimize losses should certain stocks not perform the way they are expecting.

For instance, a hedge fund manager might buy one stock while simultaneously shorting a similar stock so that if they have to sell the first stock at a loss, they’ll minimize losses by profiting off the short.

When Should You Short A Stock?

There are a few reasons you might want to consider shorting a stock, not least that shorting can be an incredibly profitable transaction if you know how to short a stock properly.

However, even when shorting looks like a good idea, it’s important to remember that shorting is an inherently high-risk investing choice.

The typical reason to short sell, if you aren’t a hedge fund manager trying to ensure profits, is that you can tell the stock is overvalued and anticipate its value decreasing soon.

Since hedging with shorts is slightly more complicated and only applies to hedge fund managers and people with very large investment portfolios, we’re mostly going to stick to the reasons regular investors might want to short.

At other times you may choose to short not because you think a stock is overvalued, but because you know that investor confidence is low, or because market trends are heading down, at least in the short term, and you think that stock is vulnerable to a correction.

You may also want to short to help protect yourself from losses related to industry-wide risks. For instance, if you own stock in a car manufacturing company, it may be a good idea to short a stock in a competing car manufacturer, so you have some protection from losses if something devalues the whole industry.

Think of problems like continued supply chain issues, steel shortages, or legislation that pressures people to choose mass transit as examples of industry-wide risks in this case.

Be careful, though, if the competitor’s stock price increases while you’re maintaining your short, it can quickly become an expensive burden on your portfolio. There are a lot of reasons shorting is considered such a high-risk trade.

We’re not going to go into a ton of detail here, but holding a short position can also be better than selling some of your stocks for tax purposes. Again, this is a much more advanced use of shorting, and we’re mostly sticking to an overview for this article.

Some short sellers also use short positions to critique the companies they are shorting. This is another advanced strategy and usually only works if you already have a recognizable name and reputation. But, shorting a company can be one way to get other investors to look more closely at the details of the business, so shorting can also influence market outcomes in some cases.

Now that you know a bit more about the main reasons you might want to short a stock, let’s talk about how to short sell stocks and the practical requirements of shorting.

How To Short Sell Stocks

Shorting takes some preparation. You can’t just decide that you want to short a stock and go out the next day and do it. Learning how to short stocks also means learning how to set yourself up to be able to short.

Here are the basics of how you’ll do it.

1. Get A Margin Account

The first and most important step is to get a margin account.

Margin accounts are different from cash accounts because they allow you to buy on margin, which means you only pay part of the stock’s price. The rest of the money is borrowed from the broker, which can increase your buying power but also comes with additional costs.

For instance, most brokers charge interest against the amount you’ve borrowed. Additionally, your margin account must maintain a certain minimum balance to maintain good standing. If you drop below your margin minimum, you may be forced to add money to the account, sell some of your stocks or short positions, or risk the broker selling your positions to make up the deficit.

Your broker asking for additional funds to be added to your margin account is called a margin call.

If you’re interested in getting a margin account, you should check the requirements with your specific broker. Since the accounts are held by the broker, each broker can have slightly different qualification requirements. Margin minimums, however, are mandated by the Federal Reserve, not the broker.

Your broker does have the option of requiring more than the Federal Reserve for their margin minimum. They just cannot go below the required minimum.

2. Make The Trade

Once you have a margin account, select the shares you want to short and make sure you’ve chosen the correct number of shares.

The higher the value of your short, the more money you can potentially make, but the greater the risk. Keep your financial position in mind when you make the trade to ensure costs don’t outweigh the potential benefits of the trade. It helps if you know how long it will take before the stock’s price drops.

Once you’ve entered the trade, the broker will purchase the stocks, providing the additional funding for buying on the margin, and sell them on the market for you.

3. Maintain The Short Position

Once you’ve entered a short, you’ll need to maintain the position for at least a little while. There are cases where shorting can be used as a day-trading tactic, and you might purchase the stocks back and close the short quickly, but most of the time, you’ll need to wait longer than that.

Ideally, you’re waiting for the stocks to reach the lowest price you anticipate them reaching. This price bottom gives you the most significant price difference, maximizing your profits.

Remember, when it comes to investing, ideal trades shouldn’t get in the way of good trades. If you aren’t sure what the price bottom will be, or if you’re concerned that your shorted stock might start to rebound, buying the stock back for any profit is better than holding until you’re at a loss.

Timing, as with all investing, is key to learning how to short sell stocks.

4. Maintain Margin Requirements

While maintaining your short position, you may have to make several margin calls because the stock price increases. You may also need to pay interest and fees on your position with the broker.

Failure to meet those requirements, including maintaining at least the margin minimum balance in your account, can result in the broker closing your position and billing you for any remaining fees and the amount they’ve lost to buy back the stocks you sold for your short.

5. Close The Short Position

Assuming you’ve maintained your short until the right moment to sell at a profit and met all your margin requirements in the meantime, it’s time to buy back the stocks.

The way this works, depending on the broker, you either indicate that you want to close your position or buy back the stocks yourself and then close your position with the broker. The broker will have a ledger showing the price you originally bought the stocks at, and the difference between the previous price and the new purchasing price is your profit.

Remember, for a successful short, the profits at the end should be greater than any money you spent on interest, fees, or margin calls.

Pros & Cons of Short Selling

Like any kind of investing, it’s important to consider the pros and cons of short selling before you commit yourself to a short.

While every trade will have its pros and cons, here are some of the general pros and cons of short selling that will apply in most cases.

Pros:

• Shorts can help protect your portfolio from unexpected market changes and industry-wide problems

• Shorts can be a good way to make large profits reasonably quickly

• Short selling can help prompt market corrections

• Shorting is often less expensive than other similarly high-value trades

• Buying on margin means you can leverage your existing resources for much more buying power.

• Shorting allows investors to continue making money even in bear markets

Cons:

• Short Squeeze can be a real risk with large short positions (short squeeze is what happens when the stock increases in price, and therefore the cost of your short increases)

• High-risk trade typically

• Timing is tricky to get right

• Requires more in-depth stock evaluation

• Shorts are not entirely predictable, and positive quarterly reports or other market shifts can quickly change your short position.

• Requires the additional risk of buying on margin

• Not accessible to new investors from either a funding or expertise perspective

• Some investors and financial firms have a negative view of short sellers

5 Risks To Consider In Short Selling

While shorting has its time and place, just like any investment tool or strategy, there are some critical risks you should consider before deciding to short a stock.

Short Selling Can Raise Stock Prices

One of the risks of short selling is that if you short a stock and other investors also see that the stock price is falling and decide to short it, you can create a short run that temporarily increases prices.

The real risk of a short run isn’t that the stock price is going to stay inflated long term. Most of the time the price will start to go back down relatively quickly so long as the influx of capital from people shorting doesn’t fix the company’s long-term problems.

No, the risk is that the price increases may price you out of being able to maintain your short and that you’ll be forced to sell early to make your next margin call.

Risk Of Infinite Losses

This is theoretical, but shorting is inherently more risky than buying and selling stocks because there is no limit on the value each stock can reach, but the value of the stock does have a floor.

Imagine you decided to short Facebook (back when it was Facebook, before the rebrand to Meta) just before the internet boom, assuming that a social networking site designed for college students would never really take off.

While Meta stock hasn’t reached infinite value, that short would have turned in impressive losses if you didn’t get out quickly when prices began to rise.

With any short, there is a risk of the company fixing their problems and increasing the value of their stocks – and costing you money in the process.

Shorting Can Create Crashes

Aggressive shorting of specific stocks is thought to be one way you can accidentally cause a crash, at least for that particular stock. In worst-case scenarios, like in 2008, the shock and systemic risk after one highly enmeshed company collapses can create market instability and cause a bear market – even in previously healthy markets.

Some theorists think that short selling was one of the reasons for Bear-Stearns’ collapse, along with all the subsequent fallout. The shorts against Lehman Bros, along with other factors, caused a cascade that also affected Bear.

Time Is Usually The Enemy Of Shorting

Because markets, on average, tend to increase in value, shorting comes with additional risks. Beyond the high risk of a company managing to solve its problems before its stocks decrease, individual stocks are more likely to go up in value over time than they are to decrease.

The longer you hold your short, the more likely it is for stock prices to begin increasing.

While timing is always important when investing and trading stocks, it’s essential for shorting because of the additional costs to maintain your short position.

The longer you have to hold your short, the harder it becomes to turn a profit even if prices don’t increase.

Shorting Assumes Nothing Will Change A Company’s Fortunes

One of the basic assumptions when you short a company, is that they are overvalued and won’t be able to do anything to make their current value accurate.

In some cases, that might be a reasonable assumption, but there are a lot of unpredictable elements in the stock markets that make this a difficult position to hold.

Even something like a well-known investor deciding to buy the stock after you’ve shorted it can be enough to cause a price increase. Politics, supply chain changes, natural disasters, and even recent news reports can change a stock’s value trajectory.

That means that shorts are even more subject to market volatility and randomness than other kinds of trades.

Cost Of Shorting Stocks

There are several costs associated with shorting stocks, here are some of the main general costs to consider.

Margin Minimums: In most cases, you’ll use margin trading to set up a short position, which means you need to have a margin minimum balance in your account. That money is untouchable, so reduces your overall buying power even if you aren’t losing it.

Interest On Your Position: Your broker will typically charge interest on any deals made on margin, including your shorts. That means that the longer you hold the short the more interest you’ll have to pay to keep it active.

Margin Calls: if the price of your shorted stock goes up, you may have a margin call to meet the costs of the deal with the new price.

Other costs can come with shorting stocks, but these are the three you typically have to think about regardless of your short position.

Examples Of Short Selling

Short selling is straightforward in examples, but remember that this is a complicated trade position to take, so while these examples are pretty simple, actual shorts rarely work out this cleanly.

Imagine you’re evaluating a gaming app company’s stock. The company has done well with previous apps, but you notice that their latest product is getting bad reviews and the company doesn’t seem to be doing much to address the problem and has admitted they don’t currently have any new apps in development.

The stock is $50, and you decide to short ten shares. So, you sell the stocks for $500 on the market.

Soon other people start to realize the same thing you have, and stock prices fall to $20 a share instead of $50. You buy back the ten stocks you sold, now for $200, and return them to the original broker. Congratulations, you made $300 on that short (without fees or interest payments for simplicity).

Now let’s imagine a less successful short.

Say that same app company you shorted (10 stocks at $50 each – for a total of $500), realizes that the reason their app was getting bad reviews was that they hadn’t adequately explained how to play the game in the app.

So they reach out to a popular streamer in their niche, offer to sponsor a few streams of the app, and immediately gain in popularity. With that win under their belt, they announce plans to start working on a sequel to the original app game, and their stock prices increase to $75 because investors are confident they’ll produce another successful game.

If you close this short now you’ll lose $250 before the additional cost of fees and interest on the short. If you hold on to the short, assuming that something will eventually reverse the company’s fortunes, you stand to lose even more – but could also turn a profit if their next release has similar issues.

Note we intentionally used something beyond investor control, a clever marketing strategy with an influencer, to mimic an otherwise unpredictable scenario. This is one of the constant risks of short selling; you cannot predict the outcome.

Both of these shorts are also very small. Most of the time, you’ll be working with much larger shorts and much larger numbers.

Controversy Of Short Selling Stocks

Short sellers are often blamed for market downturns, and short selling can be seen as hoping a company will fail.

In some ways, short sellers are one of the ways the market keeps companies honest and corrects for the overvaluation of different stocks and assets. That’s a good thing, but that doesn’t mean it makes short sellers popular people on Wall Street.

The fear is that short sellers, like people who get involved in pump and dump schemes, can cause weaknesses and problems for companies rather than just identifying and acting on them.

Because markets often follow trends and pay close attention to the actions of influential investors, another fear of short selling is that investors may follow a trend of people shorting stock without understanding the reasons for the short, and without verifying that a supposed problem exists.

Summary

Short selling is a profitable way to trade in a complicated stock market, but it’s also speculative and poses serious risks to both the investor and the market as a whole.

Because of the complications of short selling, it’s not recommended for beginners, and many experienced investors don’t mess with short selling either.

If you choose to short sell stocks it’s important to understand the risks of short selling as well as the extra work to verify that your short position makes sense and to try and eliminate unforeseen variables before making your short.

Sources

https://www.finra.org/rules-guidance/key-topics/margin-accounts
https://www.reuters.com/article/us-volkswagen/short-sellers-make-vw-the-worlds-priciest-firm-idUSTRE49R3I920081028

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The information presented is not intended to be used as the sole basis of any investment decisions, nor should it be construed as advice designed to meet the investment needs of any particular investor. Nothing provided shall constitute financial, tax, legal, or accounting advice or individually tailored investment advice. This information is for educational purposes only.