Short selling is essentially a buy or sell transaction in reverse. An investor wanting to sell shares borrows them from a broker, who sells the shares from the inventory on behalf of the person seeking to sell short. Once the shares are sold, the money from the sale is credited to the account of the short seller. In effect, the broker has loaned the shares to the short seller.
Eventually, the short sale must be closed by the seller buying an equal amount of shares with which to pay back the loan from their broker. This action is known as covering. The shares the seller buys back are returned to the broker, thus closing the transaction.
The ideal situation for the seller occurs if the stock price drops and the shares can be bought back at a lower price than the shorted price. This allows the short seller to earn a profit from a decline in the share price.
Key Takeaways
- In short selling, an investor borrows stock that they think will decline.
- The investor then sells the shares that they borrowed to buyers willing to pay the current price.
- The investor waits for the price of the borrowed shares to drop so that they can buy them back at a lower price, before returning them to the broker.
- But if the shares don't drop and instead rise, the investor will have to buy them back at a higher price than what they paid, and thus lose money.
How to Short a Stock
The concept of a short sale may initially seem complex and counterintuitive. After all, the process involves trading shares that you don't actually own, which can appear illogical. A quick overview of the shorting process might help demystify how such trades are possible.
The first step in a short sale is to identify a stock—or another asset like an exchange-traded fund (ETF)—that you believe is set to decline in value. Next, you open a short position by borrowing shares of that asset, typically from your broker. You sell these borrowed shares on the market to buyers who are willing to pay the current market price.
To close or cover your short position, you will have to return the shares you borrowed back to your broker or the entity that lent them to you. If the price declines that you anticipated have come to fruition, you can buy the replacement shares at a lower market price. And voila—you've managed to trade a stock you don't really own and profit from its decline in value.
However, if things don't play out as you planned, and the stock you've shorted gains in value, you will still have to cover your position. This means you're on the hook to buy shares at a higher price, exposing you to significant losses. In fact, since the asset's price can continue to climb, the downside risk on a short sale is theoretically unlimited.
To engage in short selling, you will need a margin account, which allows you to borrow assets from your broker-dealer. You will typically have to pay interest on the amount you borrowed while your short position is open, and regulations require you to maintain a minimum level of equity in your margin account. Brokerages set their own rules about who qualifies for margin trading.
Pros and Cons of Short Selling
Why do people use short selling? Traders may use it as speculation—a risky trading strategy in which there is the potential for both great gains and great losses. Some investors may use it as ahedge against the possibility of losing money on a bet on the same security or a related one. Hedging involves placing an offsetting risk to counter the potential downside effect of a bet on a particular security.
However, it's important to keep in mind that short selling involves high levels of risk, and it may not be the most suitable strategy for inexperienced traders and investors. With a long position, even if the share price declines to zero, the most you can lose is the amount of your original investment, In contrast, short sales expose you to potentially unlimited losses, as there's no ceiling on the price of the asset you've bet against.
Another key risk is a short squeeze, which occurs when share prices rise, and short sellers rush to cover their positions. As these traders buy shares to replace the ones they borrowed to initiate their short sale, demand increases and sends prices spiraling even higher, exacerbating the losses for those still holding short positions.
Pros
Has the potential for high profits
Can achieve positive results in difficult market conditions
Offers a way to hedge other investments
Cons
Has the potential for unlimited losses
Requires a margin account with interest charges
Vulnerable to short squeezes
Example of Short Selling
To illustrate the short-selling process, consider the following example. A seller goes through a broker and requests to sell 10 shares of a stock currently priced at $10 per share. The broker agrees, and the seller is credited with the $100 in proceeds from the sale. Over the short term,the stock drops to $5 per share. The seller uses $50 of that $100 to buy 10 shares to repay the broker and close the transaction.
The seller's remaining profit is $50, less related interest and fees. Of course, if the shares rise in price, forcing the short seller to purchase them at a higher price than the short-sale price, the seller sustains a loss.
Short selling is by nature a risky proposition. There's a massive risk of losing money on a short sale because the price of an asset can surge indefinitely.
The Cost of Waiting
Holding on to shares for long stretches of time while waiting for the security to move higher is not without cost. The seller must consider the interest the broker charges on the margin account required for short selling. Also, short sellers should consider the impact of the money tied up in the short sale that is thus not available for other transactions.
How Does a Short Sale Work?
In a short sale, a trader borrows shares from their broker and sells them on the market. If the price subsequently declines, the trader can buy the shares at a lower price and return them to the broker, earning a profit. However, if the price increases, the seller experiences significant or even unlimited losses in the process of buying and returning the shares.
What Is Naked Short Selling?
Naked short selling describes a short sale that occurs when the existence of the shares in question has not been conclusively established. To execute a legal short sale, the critical first step is borrowing the shares or determining that they are available to be borrowed. Otherwise, short positions on a stock could exceed the amount of tradable shares on the market. Although naked shorting became illegal in the wake of the 2008-2009 financial crisis, various loopholes allow the practice to continue.
Is Short Selling a Good Idea?
Short selling is a risky strategy. It can be highly profitable for advanced investors, and it is a particularly useful tool for traders to hedge other positions. However, with the potential for unlimited losses, beginners should approach short sales cautiously and educate themselves about the associated risks.
The Bottom Line
The notion of trading a stock you don't own might sound confusing or implausible, but that is what you do when you execute a short sale. The process involves borrowing shares and selling them on the market. Later, you cover your position by purchasing and returning the shares to the lender. If the share price has declined, you earn a healthy profit, but increased prices can generate steep losses.
