Short Selling Basics

what is shorting shares

Remember that if a short sale goes wrong, the loss potential is virtually unlimited, so it’s a smart idea to have a maximum loss you’re willing to take before you get started. At the end of the day, short selling is a very risky trading method that should only be done by sophisticated investors. The max loss of a long position is 100% if the stock goes to zero, but stocks can theoretically go up an infinite amount. This is exactly how short selling works, except that stock prices are much less predictable than the prices of used cars. Keep in mind that the short-selling process may be slightly different depending on the brokerage. You also need a margin account to sell short, so you should contact your broker to make sure you have the proper permissions.

  1. If the price of the stock goes down to $25 per share, you can buy the 10 shares again for only $250.
  2. As long as you can borrow the necessary shares, shorting a stock is perfectly legal.
  3. A trader who has bought stock can only lose 100% of their outlay if the stock moves to zero.
  4. One of those market signals is called short interest — the number of open short positions reported by brokerage firms on a given date.

You might even have been forced to close your position at a big loss before the trade finally started working out. The process of shorting a stock is exactly like selling a stock that you already own. If you sell shares that you don’t own, then your sell order initiates a short position, and the position will be shown in your portfolio with a minus in front of it. Because of the various risks, short selling can lead to big losses and is considered much riskier than simply buying and holding stocks. For example, the S&P 500 doubled over a five-year period from 2002 to 2007, but then plunged 55% in less than 18 months, from October 2007 to March 2009.

An individual is unlikely to impact the price with a single short sale order. However, all selling puts downward pressure on stock prices, whether it’s a short seller or a buy-and-hold investor finally deciding to sell after decades of holding the stock. If enough people sell at once, regardless of whether it’s short selling or not, it can drag down the stock price. Short selling is sometimes criticized, and short sellers are sometimes viewed as ruthless operators out to destroy companies.

How to short a stock: 6 steps

Both short-selling metrics help investors understand whether the overall sentiment is bullish or bearish for a stock. Essentially, a put option gives you the right — but not the obligation — to sell a stock at a predetermined price (known as the strike price) at any time before the option contract expires. Short-selling allows investors to profit from stocks or other securities when they go down in value. If you are planning on going short, then you should do a lot of research first.

Regulation SHO, implemented in 2005 to update previous rules, is the primary rule governing short selling. Regulation SHO mandates that short sales can only be executed in a tick-up or zero-plus tick market, meaning the security price must be moving upward at the time of the short sale. Apart from speculation, short selling has another useful purpose—hedging—often perceived as the lower-risk and more respectable avatar of shorting. The primary objective of hedging is protection, as opposed to the pure profit motivation of speculation.

However, some hedge funds have expressed concerns that these rules could expose investors’ strategies. Or betting on a decline, even when someone is not actually engaged in short selling. But there is also naked short selling — the illegal practice of short selling shares that the investor never actually obtained.

How does short selling work?

The holder of the short position must buy back their shares at current market prices to close the position and avoid further losses. This need to buy can work to bid the price of the stock even higher if there are many people trying to do the same thing. To open a short position, a trader must have a margin account and will usually have to pay interest on the value of the borrowed shares while the position is open.

what is shorting shares

So traders who believe that “the trend is your friend” have a better chance of making profitable short-sale trades during an entrenched bear market than they would during a strong bull phase. Short sellers revel in environments where the market decline is swift, broad, and deep, like the global bear market of 2008–2009, because they stand to make windfall profits during such times. Stocks typically decline much faster than they advance, and a sizable gain in the stock may be wiped out in a matter of days or weeks on an earnings miss or other bearish development. The short seller thus has to time the short trade to near perfection. Entering the trade too late may result in a huge opportunity cost for lost profits since a major part of the stock’s decline may have already occurred. For example, after oil prices declined in 2014, General Electric Co.’s (GE) energy divisions began to drag on the performance of the entire company.

The most common reasons for engaging in short selling are speculation and hedging. A speculator is making a pure price bet that the security will decline. If they are wrong, they will have to repurchase the shares at the higher price, thereby incurring a loss. Because of the additional risks in short selling due to the use of margin, it is usually conducted over a shorter time horizon and is thus more likely to be an activity conducted for speculation. There’s a ceiling on your potential profit, but there’s no theoretical limit to the losses you can suffer. For instance, say you sell 100 shares of stock short at a price of $10 per share.

A simple analogy for understanding short selling

In finance, the margin is the collateral that an investor has to deposit with their broker or exchange to cover the credit risk the holder poses for the broker or the exchange. For example, a short position cannot be established without sufficient margin. In the case of short sales, under Regulation T, the Federal Reserve Board requires all short sale accounts to have 150% of the value of the short sale at the time the sale is initiated.

Inverse ETFs

However, if you understand the risks involved but still want to short a stock, then this article explains how to do it. If this strategy works, you can make a profit by pocketing the difference between the price when you sell and the price when you buy. You will still end up with the same amount of stock of the same stock that you had originally. But a short squeeze tends to fade quickly, and within several months, Volkswagen’s stock had declined back to its normal range.

These instructions assume that you have a brokerage account that you can use to buy and sell stocks. If the stock goes down, the trader makes a profit, but there are several major risks involved. Shorting, also called short selling, is a way to bet against a stock. Short selling acts as a reality check that can eventually limit the rise of stocks being bid up to ridiculous levels during times of excessive exuberance. The SEC warns that most traders lose money in their first months of trading, and many never turn a profit. If you want to sell stock short, do not assume you’ll always be able to repurchase it whenever you want, at a price you want.

Short positions represent borrowed shares that have been sold in anticipation of buying them back in the future. As the underlying asset prices rise, investors are faced with losses to their short position. When investors are forced to buy back shares to cover their position, it is referred to as a short squeeze.

Put options provide a great alternative to short selling by enabling you to profit from a stock price drop without the need for margin. Using the scenario above, let’s now suppose the trader did not close out the short position at $40 but decided to leave it open to capitalize on a further price decline. However, a competitor swoops in to acquire the company with a takeover offer of $65 per share, and the stock soars. Use the “short” order type on your broker’s order entry system and enter the number of shares you wish to borrow and sell short. When you’re ready to exit the trade, use a “buy to cover” order to buy and return the borrowed shares. So, the idea behind buying a put option is similar to shorting, although the most you can possibly lose is what you pay for the put option.

In the above example, the other side of your short sale transaction would have been taken by a buyer of Conundrum Co. Your short position of 100 shares in the company is offset by the buyer’s long position of 100 shares. The stock buyer, of course, has a risk-reward payoff that is the polar opposite of the short seller’s payoff. In the first scenario, while the short seller has a profit of $1,000 from a decline in the stock, the stock buyer has a loss of the same amount. In the second scenario, where the stock advances, the short seller has a loss of $2,000, which is equal to the gain recorded by the buyer. One of those market signals is called short interest — the number of open short positions reported by brokerage firms on a given date.

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