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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 how to buy stocks.) 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.
What is short selling?
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 ETF or REIT), 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.
Why short a stock?
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.
How to short a stock
First you’ll need a margin account. Borrowing shares from the brokerage is effectively a margin loan, and you’ll pay interest on the outstanding debt. The process for obtaining a margin account varies by brokerage, but you’ll probably need to be approved for it.
To make the trade, you’ll need cash or stock equity in that margin account as collateral, equivalent to at least 50% of the short position’s value, according to Federal Reserve requirements. If this is satisfied, you’ll be able to enter a short-sell order in your brokerage account. It’s important to note here that you won’t be able to liquidate the cash you receive from the short sale.
To maintain the short position, the investor must keep enough equity in the account to serve as collateral for the margin loan — at least 25% per exchange rules. However, brokerages may have a higher minimum, depending on the riskiness of the stocks as well as the total value of the investor’s positions.
You can maintain the short position (meaning hold on to the borrowed shares) for as long as you need, whether that’s a few hours or a few weeks. Just remember you’re paying interest on those borrowed shares for as long as you hold them, and you’ll need to maintain the margin requirements throughout the period, too.
If the stock price falls, you’ll close the short position by buying the amount of borrowed shares at the lower price, then return them to the brokerage. Keep in mind that to earn a profit, you’ll need to consider the amount you’ll pay in interest, commission and fees.
But what if the stock price rises?
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.