Shorting a Stock: Clever or Risky?

Short selling is an investment strategy that lets you profit from falling stock prices, but it’s not for most investors.

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The commonly understood way investors make money off stocks is simple: Buy a stock with the anticipation that its price will rise over time, and if it does, sell it later for a profit. (Not sure how this works? Brush up on .) This is considered “going long.”

But stocks don’t have to go up for investors to make money off them. Investors also can profit if the stock price falls — and this is the infamous short sell.

Short selling is when a trader borrows shares from a broker and immediately sells them with the expectation that the stock price will fall shortly after. If it does, the trader can buy the shares back at the lower price, return them to the brokerage and keep the difference as profit.

Here’s an example: You borrow 10 shares of a company (or an or ), then immediately sell them on the stock market for $10 each, generating $100. If the price drops to $5 per share, you could use your $100 to buy back all 10 shares for only $50, then return the shares to the broker. In the end, you netted $50 on the short (minus any commissions, fees and interest).

That sounds simple enough, but there’s a lot more to short selling stocks than just understanding the concept, and the strategy comes with the risk of serious losses.

Investors may use a shorting strategy as a form of speculation. In other words, it’s a high-risk maneuver that could possibly yield high returns in exchange for taking on exceptional risk. Where a long-term investor may base their decision on thorough examination of the company’s financials, management and future potential, a speculator may base their decision on analysis of short-term price movements with the hope of quick profits.

Shorting a stock also can be used as a hedge. Let’s say you own shares in a company and have doubts about its near-term performance, but don’t want to sell your shares. In this instance, you could continue holding your shares for the long-term while you short the stock, buying back in at a lower price if and when the stock’s value falls. The goal here is to offset the losses of your long position.

In a traditional stock purchase, the most you can lose is the amount you paid for the shares, but the upside potential is theoretically limitless. When you short a stock, it’s the opposite — gains are maxed out at the total value of the shorted stock if the stock price falls to $0, but your losses are theoretically limitless, because the stock price can rise indefinitely.

Let’s look at the same example as above. You borrow 10 shares and immediately sell them for $10 each, generating $100. But then the shares rally to $50 each. Remember, you’re on the hook for returning the shares to the broker at some point, meaning you may have to buy them back for $500 —  a loss of $400. If the shares rally to $100 each, you’d have to buy them back for $1,000 for a loss of $900. This, in theory, can go on indefinitely, and the longer you wait for the stock price to fall again, the longer you’re paying interest on those borrowed shares.

If this happens, a short-seller might receive a “margin call” and have to put up more collateral in the account to maintain the position or be forced to close it by buying back the stock.

Given the market’s long-term upward bias, many investors find it hard to short stocks and achieve consistent, profitable results. What’s more, the risk — especially if you’re not sure what you’re doing — is much higher than a buy-and-hold strategy.

Short-sellers receive all kinds of criticism. They've been accused of hurting businesses, manipulating public opinion and spreading rumors about a company or stock. It's even been implied that short-sellers are almost unpatriotic for not supporting publicly traded companies.

But short-sellers often bring new information to light, leading the market to a more sober assessment of a company’s prospects. That can have the effect of keeping a stock at a lower price than it would have if only cheerleaders were on the sideline. The shorts help keep unbridled enthusiasm in check, and often they uncover fraud, aggressive accounting or just poorly run companies, information that may well be hiding in a company’s filings with the Securities and Exchange Commission. These are all valuable functions in the capital markets.

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