What is Short Selling?
Short selling is the practice of selling borrowed securities – such as stocks – hoping to be able to make a profit by buying them back at a price lower than the selling price. In other words, when you sell short a stock, you’re looking to profit from a decline – rather than an increase – in price.
Selling short follows the old stock trading adage to “buy low – sell high.” However, unlike in a traditional stock trade where the “buy” transaction happens first, opening a position that the sell transaction closes out, short selling puts the “sell” transaction first, opening a short position that the buy transaction closes out.
- Short selling is a strategy designed to profit from the price of market-traded security going down, rather than up.
- Many investors are confused by the concept of short selling, but its essential working is the same as for any stock trade – the trader profits when his selling price is higher than his buying price.
- It offers the advantage of leveraged trading – the ability to generate a profit with a smaller investment – but carries higher risk and higher trading costs than regular buy and sell stock trading.
How Does it Work?
Many people are at least initially confused by the concept of selling short because it involves selling something you don’t own. Conversations with one trader attempting to explain selling short to another often go something like the following:
“It’s just like a regular stock trade, except you sell it first, then buy it to close out your short position. Okay, so you think GE stock is going to go down in price. So, you open a short position by selling 100 shares of GE.”
“But wait – If I didn’t buy any GE stock first, then how can I sell GE stock? How can I sell something I don’t own.”
The way that you can sell something that you don’t own is by borrowing it. When you want to sell short, in order to get the shares to sell, you borrow them from your broker.
To get the loan of shares, you have to be approved for margin trading – a very simple process with most brokerage firms. The “margin” refers to the security deposit that you put down with your broker as collateral for the borrowed stock shares.
You must have enough cash in your stock trading account to cover the required margin – margin requirements vary among brokers.
Example – How a Short Trade Plays Out
When you enter an order to sell short, you are requesting to borrow the necessary stock shares to sell and placing an order to sell the borrowed shares per the order instructions – e.g., at a certain price.
For example, you just sold 100 shares of Company Z at the current market price of $90 per share. Just like any other time when you sell stock, the money from the sale – in this case, $9,000 ($90 x 100 shares) – is credited to your account.
In an ordinary stock trade, you would also get credited when you sell stock. However, your profit is not the total sale value, but the difference between your buy price and your sell price.
As long as your buy price is below your sell price, you profit to that extent; however, if your buy price is higher than your sell price, you lose money.
You now have a short position in the market in Stock Z and $9,000 received from your short sale. You’ve sold short, looking to profit from a decline in the market price. Assume that your forecast for Stock Z proves correct, and two weeks later, the price has gone down from $90 a share to $70 a share.
To close out your short position, you buy 100 shares of Z at $70 a share. That money comes out of the $9,000 you received when you sold Z short at $90 a share. One hundred shares at $70 a share will only cost you $7,000, leaving you a $2,000 profit from the $9,000.
Your buy price was lower than your sell price, making the trade profitable. The 100 shares of Z that you bought for $7,000 are used to repay/replace the 100 shares that you borrowed from your broker.
Selling short is simply the opposite of buying “long.” It’s just another stock trade – the only truly significant difference is which direction you expect the stock price to move in.
If you expect the stock to go up, then you buy long, hoping to profit from a price increase. Conversely, if you expect the stock to go down, then you sell short, hoping to profit from a price decrease.
There are other differences with short trades, such as the fact that you typically need to pay your broker interest on the borrowed shares. Obviously, the longer you borrow the shares for – in other words, the longer you hold your short sell position – the more interest you pay.
When you pay back your broker, you need to pay him back the borrowed shares plus a small interest fee.
To avoid any confusion, it helps to focus on the fact that in terms of profit or loss, short trades work out essentially the same as long trades. When all is said and done, you’re hoping to have closed out the trade with a sell price that’s higher than your buy price, because that means you made money on the trade.
High Potential Risk
There is one difference between buying long and selling short that makes short selling a much riskier practice – the level of risk that is inherently involved when selling short.
When you buy a stock, your total maximum risk is limited to its price. If Z stock is selling for $90 a share, you cannot lose any more than $90 a share on your investment – the absolute worst-case scenario is that Z stock goes to $0. The price of the stock isn’t going to go to a negative number, so the risk level is limited by the downside boundary at $0.
With selling short, there is no corresponding boundary on the upside. Theoretically, the stock’s price can rise infinitely higher, and therefore, the risk is also theoretically infinite.
When you sell short Z stock, your risk is not limited to a maximum of $90 per share. Its price could rise to $300, $500, or $1,000 a share. You received $9,000 for selling short 100 shares of Z. But if Z goes up to $500 a share, buying back 100 shares to pay your broker will cost you $50,000 – $41,000 more than the $9,000 you received when you sold short.
In terms of practical realities, you can limit your risk with a stop-loss order – an order to close out your market position if your loss reaches a specified amount. Just as if you’d bought Z stock at $90 a share, you’d likely close out your position in the stock long before it fell to $0 – if you sold Z short, you’d likely close out your position long before the price rose to $500 a share.
The first advantage is leverage. Since you can sell short with margin trading, only putting up a percentage of the total value of the stock you’re trading, you can make more money with a smaller investment.
Also, incorporating short-selling into your investment strategies doubles your profit opportunities, as you can make money not only from stock price increases but also from stock price decreases.
Selling short can also be used to provide additional risk protection for your overall investment portfolio. You can use some short positions to hedge long positions that you hold.
Historically, over time, stock prices tend to move higher – short trading is always trading contrary to the overall trend of the stock market as a whole.
When it comes to trading costs, in addition to the interest charges on short selling, traders may also need to pay a “hard to borrow” fee when the stock shares in question are, in fact, hard for the broker to acquire for lending purposes.
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