What is shorting a stock?

An investor borrows shares of stock from their broker. The investor’s goal is to sell those stocks at the current market rate. Then the investor buys those same stocks back at a lower price, pays back what they borrowed along with any fees, and keeps what’s leftover as profit.

An investor interested in shorting a stock generally has a margin account with a broker or brokerage firm, which allows the investor to borrow stock shares. Borrowers typically need to put up collateral for the account and undergo an eligibility process. The broker can then arrange to locate shares for the investor to borrow. The borrowed shares can then be sold by the investor, who typically aims to sell them at a higher rate. 

If the stock price falls, the investor buys back (or “covers”) the shares at the lower price. Enough shares are typically returned to the broker to pay off what is owed. The leftover money is often kept by the investor as profit. However, if the price doesn’t fall, the investor will likely need to buy back the shares at a higher price, which can lead to a loss.

Because the investor doesn’t actually own the stock, they’re “short” and need to borrow from their broker.

Investors may watch the market and pick a stock that’s currently valued high but seems likely to drop in price.

Someone may want to short sell to diversify from their more traditional, long-term investments.

Stocks can become overvalued, so short sellers might pick those stocks as part of broader market activity that can contribute to price discovery, though outcomes are influenced by many participants and factors.

There’s no guarantee a stock will decrease, and it could actually skyrocket, potentially leading to a technically unlimited amount of money to be lost.

Investors typically pay their broker interest and fees to short sell, which adds to the investor’s cost. And margin requirements are variable based on what the stock price is doing, which could mean the broker requires the investor to deposit more money in the margin account as collateral.

If other investors decide to short sell the same stock, this can make the price go up rather than drop, likely leading to a short squeeze.

If a stock has low borrowing availability, investors are likely to pay more to borrow from their broker. The broker can also ask investors to return what was borrowed (recall it) sooner than planned. In this situation, investors may have to buy the stock back at a higher price than they intended so they can pay the broker back.

Time may eat into potential short sell profits, with risks like recall or short squeeze often becoming greater the longer an investor waits to sell. Costs like broker’s fees and interest may also chip away at profits.

Stock market prices historically tend to increase, so the process of short selling is a bit like betting on a particular stock bucking that trend and dropping in price.

Short selling can work if an investor strongly suspects a stock has underlying issues, such as overvaluation, and there’s a reasonable expectation that something could happen to cause the stock’s price to drop (a catalyst).

Short selling is generally a short game rather than a long game, so it can be a viable option if investors want short-term gains.

Short selling as a hedge against risks or losses from longer-term investments may make sense. Meanwhile, pure speculation tends to have more risk because it’s usually an aggressive move to attempt a short-term profit.

Federal agencies have rules in place for short selling, like requiring a margin account. One can also mitigate risk with stop-loss orders (to limit losses) and by diversifying a portfolio through longer-term investments like traditional stock trading.

Mistake: Underestimating how high a stock can go. 

A price drop isn’t guaranteed, so it can be a good idea to set stop-loss orders to limit potential losses if the price should rise instead of fall.

Mistake: Ignoring borrow cost, margin interest, dividends owed.

Short selling typically involves fees for borrowing, including interest. And if an investor is shorting a dividend-paying stock, they are typically responsible for paying dividends to their broker.

Mistake: Holding a short too long. 

Shorting stocks isn’t necessarily a long-term strategy, and holding onto a short sell might increase risk as well as cost. 

Mistake: Failing to monitor recall risk or margin calls.

A broker can typically issue a recall any time. If the stock increases and an investor’s margin account doesn’t have enough funds, the broker may require more money or collateral from the investor. 

Mistake: Not having a clear thesis or exit plan.

Having a clear exit plan could help investors mitigate their risk in short selling.

Short selling stocks generally requires research, solid knowledge of the stock market, and frequent monitoring. By planning ahead, investors can take certain steps that may help them better understand and manage the risks involved. Outcomes depend heavily on market conditions and individual execution.

The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.