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Are you bearish on a stock that keeps going up and up and up?
Do you believe it is far overvalued based on the company’s fundamentals?
It’s possible to make money when a stock price is falling — if you’re willing to accept the risks.
By a process known as short selling (also known as “selling short”, “going short”, or simply “shorting”), you can speculate and profit on the decline of a stock’s price.
Many investors may also use shorting as a hedge against the downside risk of a long position in a related security.
Although the concept of short selling is simple, it should only be used by advanced traders willing to undertake large risks.
Unlike buying a stock, where the max loss is only the initial amount of the investment, the max loss is infinite when short selling a stock.
What Does it Mean to “Short a Stock”?
Short selling works like this: An investor borrows shares of a stock and immediately sells the shares at the current price.
Then, at a later date, the investor buys the shares back and returns them to the lender.
The short seller is wagering that the stock will drop in price. If the stock drops after short selling, the investor buys it back at a lower price and returns it to the lender.
The seller’s profit is the difference between the sell price and the buy price.
Advantages of Shorting a Stock
Short selling is a relatively simple way to speculate on a decline in a stock’s price or to hedge a long position.
Hedge funds and very experienced traders are the most frequent to engage in short-selling strategies, indicating the skill required but also the potential for profit.
Short selling also allows for the opportunity to make profits in a broad-based, declining market.
Disadvantages of Shorting a Stock
The biggest disadvantage to short selling is the amplification of risk.
As mentioned previously, when you buy a stock, you stand to lose only the amount you have invested.
So, if you bought one share of Tesla at $1,030, your max loss is $1,030 if Tesla falls to $0.
However, when an investor short sells, their max loss is technically infinite. This is because a stock’s price can keep rising forever, never giving the investor an opportunity to exit their position.
Example of Shorting a Stock
Let’s take a look at an example.
An investor who believes Tesla (NASDAQ: TSLA) is overvalued at $1,030 per share.
The investor could “borrow” 10 shares from their broker and sell those shares at the current price.
If the stock falls to $750, the investor could buy the 10 shares back and return them to their broker.
This would net a profit of $2,800 ($10,030 - $7,500).
However, if Tesla’s price rises to $1,200, the investor would have a loss of $1,700 ($10,030 - $12,000), which they would have to either close or decide to continue holding.
What is a Short Squeeze?
A short squeeze happens when a stock with a large short interest (a stock that has been heavily sold short) climbs rapidly in price.
This triggers short sellers to buy back their shorted shares to cap their losses, dramatically steepening the price ascent in a self-stoking cycle.
When Short Selling is Good...
Short selling is not a strategy many investors use because the borrowing costs are expensive and stocks are expected to rise in value over time.
So, the best time to short a stock is when you have a high degree of confidence in a stock dropping significantly in the short term.
Stocks usually fall much faster than they rise. This plays into the hands of short sellers who want to see their positions profit quickly but lose money slowly.
Most commonly, retail traders will engage in short selling on stocks they already own as a hedge for their long positions.
For example, suppose an investor owns shares of ABC and expect it to weaken over the next few months, but does not want to sell the stock.
The investor may hedge their long position by shorting ABC while they expect it to weaken and then close the short position when they expect the stock to strengthen.
When Short Selling is Bad...
There are several costs involved in short selling such as:
- margin interest
- stock borrowing costs
- missing out on dividends
It is also capital intensive and highly risky because you can lose more than you have invested in a short sale.
Additionally, the maximum profit on shorting is only 100% because the lowest price the stock can reach is $0.
Investors engaging in short selling must have an incredibly high tolerance for risk and be prepared for heavy losses.
Short sellers only make money when they are right and are right quickly.
The Bottom Line: Short Selling
The process of short selling a stock is simple but should not be done by inexperienced traders.
Losses can build quickly even when your thesis on the underlying company’s fundamentals is playing out — there’s never a guarantee a stock will fall, even if it should.
For savvy investors, though, it’s an excellent tool for both speculation and hedging purposes.
Properly managing risk is of the utmost importance, but when used in moderation, short-selling can greatly diversify a portfolio’s exposure and give you the opportunity to outperform the market — if you know exactly what you’re doing.
