Short selling is a strategy for making money on stocks falling in price, also called “going short” or “shorting.” This is an advanced strategy only experienced investors and traders should try. An investor borrows a stock, sells it, and then buys the stock back to return it to the lender.
Short sellersare wagering that thestock they’re shorting will drop in price. If this happens, they will get it back at a lower price and return it to the lender. The short seller’s profit is the difference in price between when the investor borrowed the stock and when they returned it.
Key Takeaways
- Short sellersare wagering that astock will drop in price.
- Short selling is riskier than going long because there's no limit to the amount you could lose.
- Speculators short-sell to capitalize on a decline. Hedgers go short to protect gains or to minimize losses.
- Short selling can net the investor a decent profit in the short term when it's successful since stocks tend to lose value faster than they appreciate.
- Inexperienced investors may quickly find that short selling isn't to their advantage.
Example of a Short Sale
Suppose you think that Company X is overvalued at $200per share and that its price is due to go down.
You “borrow” 10 shares of Company X from a broker and then sell the shares for the market price of $200. Let’s say all goes as planned, and later, you buy back the 10 shares at $125 after the stock price has gone down and return the borrowed shares to the broker. You would net $750 ($2,000 - $1,250).
Let’s suppose, instead, that Company X's price increases to $250 a share: you would lose $500 ($2,000 - $2,500).
Short-Selling Risks
Short selling amplifies risk. If investors buy a stock or “go long," they stand to lose only the money they’ve put in. Based on the example above, if investors bought Company X at $200, the maximum they could lose is $200 for each share because the lowest any stock can go is $0.
However, there’s no such limit when investors short sell because a stock’s price can keep rising without limit.
For example, you would lose $175 per share if you had a short position in Company X (having borrowed the stock at $200 per share), and the price rose to $375before you got out. Since there is no limit to how high Company X's stock price can rise, there’s no limit to the losses for the short sellers involved.
Another risk is a short squeeze as a stock climbs rapidly in price. When this happens, short sellers race to buy the stock back as it goes higher to cut their losses. This buying activity then drives the stock price up still further. This typically happens with stocks that have high short interest, meaning a large part of the stock’s available shares are sold short.
Short Squeeze
The most-publicized contemporary example of a short squeeze occurred when followers of WallStreetBets, a popular Reddit page, came together in January 2021.
They wanted to generate a massive short squeeze in the stocks of struggling companies with very high short interest, such as the video game retailer GameStop Corp. (GME). The purchases of the stock by those following the Reddit page soon caused the company’s share price to soar 17-fold in January alone, squeezing major hedge funds that shorted the stock.
Short selling can only be undertaken through a margin account, which brokerages use to lend funds to investors trading securities. Short sellers need to monitor their margin accounts closely to ensure it has enough value to maintain their short positions.
If the stock that was sold short suddenly spikes in price, the trader will have to pump more funds quickly into the margin account. This might happen if the company whose stock has been shorted announces earnings that exceed expectations.
If the investor doesn't make interest payments, or losses are mounting quickly, the brokerage might forcibly close out the short position and saddle the trader with whatever losses have accrued at the time.
Why Do Investors Go Short?
Short selling can be used for speculation or hedging. Speculators use short selling to capitalize on a potential decline in a specific security or the market as a whole. Hedgers use the strategy to protect gains or mitigate losses in a security or portfolio, using it as a form of insurance.
Speculation Example
This is similar to our examples of short selling thus far. For example, a speculator believes that Company X, trading at $200 per share, is overvalued and will likely see its stock price decline in the coming months.
The speculator borrows shares of Company X and sells them at the current market price of $200. A few months later, as anticipated, the stock falls to $125 per share. The speculator then buys back the same number of shares at this lower price to return them to the lender, profiting from the difference of $75 per share.
Hedging Example
This time, the investor holds a significant number of Company X shares. Say the company has been performing well and currently trades at $200 per share. The investor expects short-term market volatility that might cause a temporary drop in Company X's stock price but does not want to sell the shares as part of a long-term strategy.
To protect the portfolio, the investor short-sells shares of Company X as a hedge. If its price drops, the loss in the investor's long position will be offset by gains in the short position, thus reducing the overall loss in its portfolio. When the market stabilizes, the investor can close the short position by buying back the shares while maintaining their long-term position in Company X.
Experienced investors frequently engage in short selling for both purposes simultaneously. Hedge funds are among the most active short sellers and often use shorts in select stocks or sectors to hedge their long positions in other stocks.
When Does Short Selling Make Sense?
Buying stocks is less risky than short selling for the typical investor with a long-term investment horizon. Short selling isn't a strategy used in most trades because stocks are expected to follow past performance and rise over time. Nevertheless, economic history has been punctuated by bear markets when stocks tumble significantly.
Short selling makes sense for investors convinced that a stock's price will decline. There could be many reasons for that view—anticipated negative company news, like the expectation that a drug company's main medication won't pass its medical trials; overvaluation based on fundamental analysis; broader market or sector downturns; or simply the consideration that a much-hyped stock or sector can only fly high for so long.
However, short selling carries a high risk since losses can be unlimited if the stock price continues to rise. Short sellers can't just invest and try to forget their positions, as long-term investors can do.
They have to monitor their positions closely and be prepared for a short squeeze, which can lead to rapid losses. Only advanced investors with a high risk tolerance and an understanding of the risks associated with short selling should attempt it.
Restrictions on Short Selling
Short selling has always faced detractors who chafe at the idea of people profiting from the misery or losses of others. Shorting has also been blamed for market crashes since it can increase volatility. The U.S. regulates short selling to ensure market integrity and protect investors. Here are some of the key rules:
The Alternative Uptick Rule
In 1938, the Securities and Exchange Commission (SEC) enacted its uptick rule, designed to promote market stability and answer to charges that shorting helped bring about the market crash almost a decade earlier. This rule allowed short selling of a stock only on an uptick, meaning the sale price had to be higher than the last. Simply put, you could only short stocks going up in price.
However, the SEC removed the uptick rule in 2007 and introduced its alternative uptick rule in 2010, after the 2007-2008 financial crisis.
The alternative goes into effect when the price of a security has droppedby 10% or more from the previous day's closing price. Short selling is permitted at this point only if the price is above the currentbest bid. The alternative uptick rule generally applies to all securities and stays in effect for the rest of the day and the following trading session.
Regulation SHO
The key regulation overseeing short selling in the U.S. is Regulation SHO, which requires brokers to have reasonable confidence a security can be borrowed before approving a short sale—a provision called the “locate” requirement.
The regulation was implemented in 2005 over concerns that failures to deliver (FTDs) stocks in short sales were increasing. This is believed to occur more often when there is naked short selling in the market.
Regulation SHO also formally bans naked short selling, the practice of selling shares you haven’t borrowed and haven’t confirmed can be made available.
Threshold Securities List
Another regulation connected to Regulation SHO is the threshold securities list. This is a publicly available list of securities with FTDs for five or more consecutive trading days and is used by regulators to identify potential cases of market manipulation.
Reporting Requirements
In 2023, the SEC introduced new rules requiring investors to report their short positions and the brokers that lend out securities to report all activity to theFinancial Industry Regulatory Authority (FINRA).
Bringing greater transparency to short sales became a priority following the 2021 “meme stock” phenomenon. Retail investors significantly drove up the price of GameStop, a stock heavily shorted by hedge funds, leading to questions about the opaque nature of short selling and the potential for manipulating markets through shorting transactions.
A Short-Selling Alternative With Less Risk
An alternative to short selling is to buy a put option on the same stock. This limits your downside exposure. Holding a put option gives you the right but not the obligation to sell the underlying stock at a specific strike price.
Your loss would be limited to the amount paid for the put option if the price of the stock rises rather than falls. You would then be responsible for this amount, called the option premium, plus any commissions.
Example of the Put Option Alternative to Shorting
Say Company X was trading at about $200 on March 4. A put option with a strike price of $200 that expired March 18 costs about $13 per share (the option premium plus commissions). If the price of Company X rose above $200, the investor’s loss would be limited to $13 per share plus commissions.
Note
The option premium varies based on the strike price and the expiration date of the put option. The higher the strike price and the longer the time until the expiration date, the higher the option premium.
Costs of Short Selling
Trading commissions aren't the only expenses for short selling. Here are other costs:
- Margin interest: Short selling can only be done through a margin account, and the short seller pays interest on the borrowed securities and funds.
- Stock-borrowing costs: The shares of some companies are difficult to borrow because of high short interest or limited share float, its availability for trading. In this case, the trader usually pays a hard-to-borrow fee based on an annualized rate that can become quite costly.
- Dividends and other payments: A short seller is also on the hook to make dividend payments on the shorted stock, as well as payments from other events, such as stock splits and spinoffs.
What Is the Maximum Profit You Can Make From Short Selling a Stock?
The maximum profit you can make from short-selling a stock is 100% because the lowest price at which a stock can trade is $0. However, the maximum profit in practice is due to be less than 100% once stock-borrowing costs and margin interest are included.
Can You Really Lose More Than You've Invested in a Short Sale?
Yes. Your losses can be infinite. This is the reverse of a conventional long strategy in which the maximum gain on a stock you’ve purchased is theoretically infinite, but the most you can lose is the amount invested. For example, an investor with a short position of 100 shares in GameStop on Dec. 31, 2020, would have faced a loss of $306.16 per share or $30,616 if the short position had still been open on Jan. 29, 2021. The stock soared from $18.84 to $325.00 that month, so the investor’s return would have been -1,625%.
Is Short Selling Bad for the Economy?
Short selling has a negative reputation because some unscrupulous short sellers have used unethical tactics to drive down stock prices. However, when done legally, short selling facilitates the smooth functioning of financial markets because it provides market liquidity. Shorting also acts as a reality check for investors’ unrealistic expectations and reduces the risk of market bubbles.
What Is a Margin Call?
You trade on margin when using a security or capital borrowed from your broker, along with your own money. A margin call occurs when the value of the margin account falls below a specific level. This can occur if you’re short-selling and there’s a short squeeze. At this point, you have to deposit more funds or securities into the margin account. Your broker may require you to sell securities at market price to meet the margin call if you don’t deposit the necessary funds.
The Bottom Line
You can make a healthy profit by short-selling a stock that later loses value, but you can rack up significant and theoretically infinite losses if the stock price goes up instead.
Short selling also leaves you at risk of a short squeeze when a rising stock price forces short sellers to buy shares to cover their position. This causes prices to spiral even higher. Short selling is not a good strategy for inexperienced investors who are unaware of the risks involved in such moves.
