What Is Short Selling?
Short selling is an investment or trading strategy that speculates on the decline in a stock or other security’s price. It is an advanced strategy that should only be undertaken by experienced traders and investors.
Traders may use short selling as speculation, and investors or portfolio managers may use it as a hedge against the downside risk of a long position in the same security or a related one. Speculation carries the possibility of substantial risk and is an advanced trading method. Hedging is a more common transaction involving placing an offsetting position to reduce risk exposure.
In short selling, a position is opened by borrowing shares of a stock or other asset that the investor believes will decrease in value. The investor then sells these borrowed shares to buyers willing to pay the market price. Before the borrowed shares must be returned, the trader is betting that the price will continue to decline and they can purchase the shares at a lower cost. The risk of loss on a short sale is theoretically unlimited since the price of any asset can climb to infinity.
- Short selling occurs when an investor borrows a security and sells it on the open market, planning to buy it back later for less money.
- Short sellers bet on, and profit from, a drop in a security’s price. This can be contrasted with long investors who want the price to go up.
- Short selling has a high risk/reward ratio: It can offer big profits, but losses can mount quickly and infinitely due to margin calls.
Understanding Short Selling
With short selling, a seller opens a short position by borrowing shares, usually from a broker-dealer, hoping to buy them back for a profit if the price declines. Shares must be borrowed because you cannot sell shares that do not exist. To close a short position, a trader buys the shares back on the market—hopefully at a price less than at which they borrowed the asset—and returns them to the lender or broker. Traders must account for any interest charged by the broker or commissions charged on trades.
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. Also, the Financial Industry Regulatory Authority (FINRA), which enforces the rules and regulations governing registered brokers andbroker-dealerfirms in the United States, the New York Stock Exchange (NYSE), and the Federal Reserve have set minimum values for the amount that the margin account must maintain—known as the maintenance margin. If an investor’s account value falls below the maintenance margin, more funds are required, or the position might be sold by the broker.
The process of locating shares that can be borrowed and returning them at the end of the trade is handled behind the scenes by the broker. Opening and closing the trade can be made through the regular trading platforms with most brokers. However, each broker will have qualifications that the trading account must meet before they allow margin trading.
Why Sell Short?
The most common reasons for engaging in short selling are speculation and hedging. A speculator is making a pure price bet that it will decline in the future. If they are wrong, they will have to buy the shares back higher, at a loss. Because of the additional risks in short selling due to the use of margin, it is usually conducted over a smaller time horizon and is thus more likely to be an activity conducted for speculation.
People may also sell short to hedge a long position. For instance, if you own call options (which are long positions), you may want to sell short against that position to lock in profits. Or, if you want to limit downside losses without actually exiting a long stock position, you can sell short in a stock that is closely related to or highly correlated with it.
Example of Short Selling for a Profit
Imagine a trader who believes that XYZ stock—currently trading at $50—will decline in price in the next three months. They borrow 100 shares and sell them to another investor. The trader is now “short” 100 shares since they sold something that they did not own but had borrowed. The short sale was only made possible by borrowing the shares, which may not always be available if the stock is already heavily shorted by other traders.
A week later, the company whose shares were shorted reports dismal financial results for the quarter, and the stock falls to $40. The trader decides to close the short position and buys 100 shares for $40 on the open market to replace the borrowed shares. The trader’s profit on the short sale, excluding commissions and interest on the margin account, is $1,000 ($50 - $40 = $10 × 100 shares = $1,000).
Example of Short Selling for a Loss
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.
If the trader decides to close the short position at $65, the loss on the short sale would be $1,500 ($50 - $65 = negative $15 × 100 shares = $1,500 loss). Here, the trader had to buy back the shares at a significantly higher price to cover their position.
Example of Short Selling as a Hedge
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. Hedging is undertaken to protect gains or mitigate losses in a portfolio, but since it comes at a significant cost, the vast majority of retail investors do not consider it during normal times.
The costs of hedging are twofold. There’s the actual cost of putting on the hedge, such as the expenses associated with short sales, or the premiums paid for protective options contracts. Also, there’s the opportunity cost of capping the portfolio’s upside if markets continue to move higher. As a simple example, if 50% of a portfolio that has a close correlation with the Standard & Poor’s 500 Index (S&P 500) is hedged, and the index moves up 15% over the next 12 months, the portfolio would only record approximately half of that gain, or 7.5%.
Pros and Cons of Short Selling
Selling short can be costly if the seller guesses wrong about the price movement. A trader who has bought stock can only lose 100% of their outlay if the stock moves to zero.
However, a trader who has shorted stock can lose much more than 100% of their original investment. The risk comes because there is no ceiling for a stock’s price—it can rise “to infinity and beyond,” to coin a phrase from comic character Buzz Lightyear. Also, while the stocks were held, the trader had to fund the margin account. Even if all goes well, traders have to figure in the cost of the margin interest when calculating their profits.
Possibility of high profits
Little initial capital required
Leveraged investments possible
Hedge against other holdings
Potentially unlimited losses(Video) Short Selling: Definition, Pros, Cons, and Examples
Margin account necessary
Margin interest incurred
When it comes time to close a position, a short seller might have trouble finding enough shares to buy—if a lot of other traders are also shorting the stock or if the stock is thinly traded. Conversely, sellers can get caught in a short squeeze loop if the market, or a particular stock, starts to skyrocket.
On the other hand, strategies that offer high risk also offer a high-yield reward. Short selling is no exception. If the seller predicts the price moves correctly, they can make a tidy return on investment (ROI), primarily if they use margin to initiate the trade. Using margin provides leverage, which means the trader did not need to put up much of their capital as an initial investment. If done carefully, short selling can be an inexpensive way to hedge, providing a counterbalance to other portfolio holdings.
Beginning investors should generally avoid short selling until they get more trading experience under their belts. That being said, short selling through exchange-traded funds (ETFs) is a somewhat safer strategy due to the lower risk of ashort squeeze.
Additional Considerations with Short Selling
Besides the previously mentioned risk of losing money on a trade from a stock’s price rising, short selling has additional risks that investors should consider.
Shorting Uses Borrowed Money
Shorting is known asmargin trading.When short selling, you open a margin account, which allows you to borrow money from the brokerage firm using your investment as collateral.Just as when you go long on margin, it’s easy for losses to get out of hand because you must meet the minimum maintenance requirement of 25%. If your account slips below this, you’ll be subject to amargin call and forced to put in more cash or liquidate your position.
Even though a company is overvalued, it could conceivably take a while for its stock price to decline. In the meantime, you are vulnerable to interest, margin calls, and being called away.
If a stock is actively shorted with a high short float and days-to-cover ratio (more on that below), it is also at risk of experiencing a short squeeze. A short squeeze happens when a stock begins to rise, and short sellers cover their trades by buying their short positions back. This buying can turn into a feedback loop. Demand for the shares attracts more buyers, which pushes the stock higher, causing even more short sellers to buy back or cover their positions.
Regulators may sometimes impose bans on short sales in a specific sector, or even in the broad market, to avoid panic and unwarranted selling pressure. Such actions can cause a sudden spike in stock prices, forcing the short seller to cover short positions at huge losses.
Going Against the Trend
History has shown that, in general, stocks have an upward drift. Over the long run, most stocks appreciate in price. For that matter, even if a company barely improves over the years, inflation or the rate of price increase in the economy should drive its stock price up somewhat. This means that shorting is betting against the overall direction of the market.
Costs of Short Selling
Unlike buying and holding stocks or investments, short selling involves significant costs, in addition to the usual trading commissions that have to be paid to brokers. Some of the costs include:
Margin interest can be a significant expense when trading stocks on margin. Since short sales can only be made via margin accounts, the interest payable on short trades can add up over time, especially if short positions are kept open over an extended period.
Stock Borrowing Costs
Shares that are difficult to borrow—because of high short interest, limited float, or any other reason—have “hard-to-borrow” fees that can be quite substantial. The fee is based on an annualized rate that can range from a small fraction of a percent to more than 100% of the value of the short trade and is prorated for the number of days that the short trade is open.
As the hard-to-borrow rate can fluctuate substantially from day to day and even on an intraday basis, the exact dollar amount of the fee may not be known in advance. The fee is usually assessed by the broker-dealer to the client’s account either at month-end or upon closing of the short trade—and if it is quite large, can make a big dent in the profitability of a short trade or exacerbate losses on it.
Dividends and Other Payments
The short seller is responsible for making dividend payments on the shorted stock to the entity from whom the stock has been borrowed. The short seller is also on the hook for making payments on account of other events associated with the shorted stock, such as share splits, spinoffs, and bonus share issues, all of which are unpredictable events.
Short Selling Metrics
Two metrics used to track short-selling activity on a stock are:
- Short interest ratio (SIR)—also known as the short float—measures the ratio of shares that are currently shorted compared to the number of shares available or “floating” in the market. A very high SIR is associated with stocks that are falling or stocks that appear to be overvalued.
- The short interest to volume ratio—also known as the days-to-cover ratio—is the total shares held short divided by the average daily trading volume of the stock. A high value for the days-to-cover ratio is also a bearish indication for a stock.
Both short-selling metrics help investors understand whether the overall sentiment is bullish or bearish for a stock.
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 short interest ratio jumped from less than 1% to more than 3.5% in late 2015 as short sellers began anticipating a decline in the stock. By the middle of 2016, GE’s share price had topped out at $33 per share and began to decline. By February 2019, GE had fallen to $10 per share, which would have resulted in a profit of $23 per share to any short sellers lucky enough to short the stock nearthe top in July 2016.
Ideal Conditions for Short Selling
Timing is crucial when it comes to short selling. Stocks typically decline much faster than they advance, and a sizable gain in a 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 in terms of lost profits, since a major part of the stock’s decline may have already occurred.
On the other hand, entering the trade too early may make it difficult to hold on to the short position in light of the costs involved and potential losses, which would skyrocket if the stock increases rapidly.
There are times when the odds of successful shorting improve, such as the following:
During a Bear Market
The dominant trend for a stock market or sector is down during a bear market. 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 2008–09—because they stand to make windfall profits during such times.
When Stock or Market Fundamentals Are Deteriorating
A stock’s fundamentals can deteriorate for any number of reasons—slowing revenue or profit growth, increasing challenges to the business, rising input costs that are putting pressure on margins, and so on. For the broad market, worsening fundamentals could mean a series of weaker data that indicate a possible economic slowdown, adverse geopolitical developments like a threat of war, or bearish technical signals like reaching new highs on decreasing volume, deteriorating market breadth.
Experienced short sellers may prefer to wait until the bearish trend is confirmed before putting on short trades, rather than doing so in anticipation of a downward move. This is because of the risk that a stock or market may trend higher for weeks or months in the face of deteriorating fundamentals, as is typically the case in the final stages of a bull market.
Technical Indicators Confirm the Bearish Trend
Short sales may also have a higher probability of success when the bearish trend is confirmed by multiple technical indicators. These indicators could include a breakdown below a key long-term support level or a bearish moving average crossover like the death cross. An example of a bearish moving average crossover occurs when a stock’s 50-day moving average falls below its 200-day moving average. A moving average is merely the average of a stock’s price over a set period of time. If the current price breaks the average, either down or up, it can signal a new trend in price.
Valuations Reach Elevated Levels Amid Rampant Optimism
Occasionally, valuations for certain sectors or the market as a whole may reach highly elevated levels amid rampant optimism for the long-term prospects of such sectors or the broad economy. Market professionals call this phase of the investment cycle “priced for perfection,” since investors will invariably be disappointed at some point when their lofty expectations are not met. Rather than rushing in on the short side, experienced short sellers may wait until the market or sector rolls over and commences its downward phase.
John Maynard Keynes was an influential British economist whose economic theories are still in use today. However, Keynes was quoted as saying, “The market can stay irrational longer than you can stay solvent,” which is particularly apt for short selling. The optimal time for short selling is when there is a confluence of the above factors.
Short Selling’s Reputation
Sometimes short selling is criticized, and short sellers are viewed as ruthless operators out to destroy companies. However, the reality is that short selling provides liquidity—meaning enough sellers and buyers—to markets and can help prevent bad stocks from rising on hype and over-optimism. Evidence of this benefit can be seen in asset bubbles that disrupt the market. Assets that lead to bubbles such as the mortgage-backed security (MBS) market before the 2008 financial crisis are frequently difficult or nearly impossible to short.
Short-selling activity is a legitimate source of information about market sentiment and demand for a stock. Without this information, investors may be caught off-guard by negative fundamental trends or surprising news.
Unfortunately, short selling gets a bad name due to the practices employed by unethical speculators. These unscrupulous types have used short-selling strategies and derivatives to artificially deflate prices and conduct bear raids on vulnerable stocks. Most forms of market manipulation like this are illegal in the U.S. but still happen periodically.
Put options provide a great alternative to short selling by enabling you to profit from a drop in a stock’s price without the need for margin or leverage. If you’re new to options trading, Investopedia’sOptions for Beginners course provides a comprehensive introduction to the world of options. Its five hours of on-demand video, exercises, and interactive content offer real strategies to increase consistency of returns and improve the odds in the investor’s favor.
Real-World Example of Short Selling
Unexpected news events can initiate a short squeeze, which may force short sellers to buy at any price to cover their margin requirements. For example, in October 2008, Volkswagen briefly became the most valuable publicly traded company in the world during an epic short squeeze.
In 2008, investors knew that Porsche was trying to build a position in Volkswagen and gain majority control. Short sellers expected that once Porsche had achieved control over the company, the stock would likely fall in value, so they heavily shorted the stock. However, in a surprise announcement, Porsche revealed that they had secretly acquired more than 70% of the company using derivatives, which triggered a massive feedback loop of short sellers buying shares to close their position.
Short sellers were at a disadvantage because 20% of Volkswagen was owned by a government entity that wasn’t interested in selling, and Porsche controlled another 70%, so there were very few shares available on the market—float—to buy back. Essentially, both the short interest and days-to-cover ratio had exploded higher overnight, which caused the stock to jump from the low €200s to more than €1,000.
A characteristic of a short squeeze is that they tend to fade quickly, and within several months, Volkswagen’s stock had declined back to its normal range.
Why is it called selling short?
A short position is one that bets against the market, profiting when prices decline. To sell short is to take such a bet. This is opposed to a long position, which involves buying an asset in hopes that the price will rise.
Why do short sellers have to borrow shares?
You cannot sell something that doesn’t exist. Since a company has a limited number of shares outstanding, a short seller must first locate some of those shares to sell them. The short seller, therefore, borrows those shares from an existing long and pays interest to the lender. This process is often facilitated behind the scenes by one’s broker. If there are not many shares available for shorting (i.e., hard to borrow), then the interest costs to sell short will be higher.
Is short selling bad?
While some people think it is unethical to bet against the market, most economists and financial professionals agree that short sellers provide liquidity and price discovery to a market, making it more efficient.
Can I sell short in my brokerage account?
Many brokers allow short selling in individual accounts, but you must first apply for a margin account.
What is a short squeeze?
Because short sales are sold on margin, relatively small losses can lead to ever larger margin calls. If a margin call cannot be met, the holder of the short position must buy back their shares at ever higher prices. This works to bid the price of the stock even higher.
The Bottom Line
Short selling allows investors and traders to make money from a down market. Those with a bearish view can borrow shares on margin and sell them in the market, hoping to repurchase them at some point in the future at a lower price.
While some have criticized short selling as a bet against the market, many economists believe that the ability to sell short makes markets more efficient and can actually be a stabilizing force. Technical traders and analysts often look at a stock’s short interest and other ratios involving short positions to inform trading ideas. However, large short positions can become squeezed due to margin calls. The buying that is required to close short positions can force prices higher and accelerate a rally, making losses to shorts even more severe.
- Selling short offers diversification.
- Selling short offers reduced volatility.
- Selling short hedges your portfolio.
- Selling short is betting against the upward drift.
- Selling short has limited upside and unlimited downside.
- Selling short is hard because stocks and markets fall hard and fast.
You borrow 100 shares and sell them for $5,000. The price suddenly declines to $25 a share, at which point you purchase 100 shares to replace those you borrowed, netting $2,500. Short selling may sound straightforward, but this kind of speculative trading involves considerable risk.What are three cons of short selling? ›
- Borrowed Money. This strategy is known as margin trading. ...
- Timing Could Be Wrong. Even if a certain company is overvalued, it may take some time before their stock prices decline. ...
- Risks of Regulation. Sometimes, regulators may end up imposing bans on short trading in a certain sector.
Short selling is the selling of a stock that the seller doesn't own. More specifically, a short sale is the sale of a security that isn't owned by the seller, but that is promised to be delivered.What are the cons of a short sale? ›
- Long Process. ...
- Subject to the Mortgage Lender's Approval. ...
- Lender Could Counter, Reject or Not Respond. ...
- Opportunity Cost. ...
- Property 'As Is' ...
- Is the Seller Approved? ...
- Lenders Prefer All Cash or Large Down Payments.
Of the short selling benefits, the most obvious is that short selling can give you a profit without putting much money up front. If you make the right decisions about the stock and the stock price plunges, you'll make money. It has the potential to be incredibly lucrative in certain stock market situations.What is shorting in simple words? ›
Definition: In capital markets, the act of selling a security at a given price without possessing it and purchasing it later at a lower price is known as shorting.Is short selling a problem? ›
Shorting allows a cleaner expression of a view on a particular stock or sector while also reducing volatility and risk of loss. The approach does not affect the health of individual companies, is typically low profile and doesn't raise ethical concerns in our view.What are the two types of short selling? ›
Short selling: the two key types. Covered short selling. Uncovered (naked) short selling. Naked short selling: settlement risk.How does short selling hurt a stock? ›
It is widely agreed that excessive short sale activity can cause sudden price declines, which can undermine investor confidence, depress the market value of a company's shares and make it more difficult for that company to raise capital, expand and create jobs.
“I think the main reason people dislike short selling is that something just feels bad about profiting from someone else's failures,” said Sasha Indarte, an assistant professor of finance at the University of Pennsylvania's Wharton School. “Short sellers gain when someone else loses.What risk do short sellers face? ›
Short sellers face unique risks, such as the risk that stock loans become expensive and the risk that stock loans are recalled. We show that short selling risk affects prices among the cross-section of stocks. Stocks with more short selling risk have lower returns, less price efficiency, and less short selling.Is short selling a good strategy? ›
The bottom line. Short selling is essentially a bearish or pessimistic move, requiring a stock to decline for the investor to make money. It's a high-risk, short-term trading strategy that requires close monitoring of your shares and of the market.What are the types of shorting? ›
- A short position refers to a trading technique in which an investor sells a security with plans to buy it later.
- Shorting is a strategy used when an investor anticipates that the price of a security will fall in the short term.
Shorting stocks is a way to profit from falling stock prices. A fundamental problem with short selling is the potential for unlimited losses. Shorting is typically done using margin and these margin loans come with interest charges, which you have pay for as long as the position is in place.Why do short sales fail? ›
Just because a seller accepts a short sale price doesn't mean that the lender will, and the list price may be far below what the lender wants. Banks may reject offers when the price is low, the seller or buyer doesn't qualify, the application is incomplete, or the loan has already been sold.Who benefits from shorting a stock? ›
In a short sale transaction, a broker holding the shares is typically the one that benefits the most, because they can charge interest and commission on lending out the shares in their inventory. The actual owner of the shares does not benefit due to stipulations set forth in the margin account agreement.What is the full meaning of short? ›
adjective. of little length; not long. of little height; not tall.How to do short selling? ›
To short a stock, you'll need to have margin trading enabled on your account, allowing you to borrow money. The total value of the stock you short will count as a margin loan from your account, meaning you'll pay interest on the borrowing. So you'll need to have enough margin capacity, or equity, to support the loan.What is shorting how is it useful? ›
Shorting is a trading strategy that relies on the expectation of a future market crash. The trader opens a position by borrowing shares, and then when it plunges, they sell the shares. With this strategy, investors can purchase the shares at a lower price than the one at which they were originally sold.
Short Selling Becomes Legitimate
This rule prevented short selling at successively lower prices, a strategy intended to drive a stock price down artificially. The uptick rule allowed unrestricted short selling when the market was moving up, increasing liquidity, and acting as a check on upside price swings.
- Open a Margin Account With Your Brokerage Firm. ...
- Identify the Type of Account You Want to Open. ...
- Direct Your Broker to Execute a Short Sale on a Specific Stock. ...
- Make Sure You Know the Rules Before You Sign Off on the Short Sale Order. ...
- Buy the Stock Back and Pay Off the Loan.
The Short Selling Regulation regulates the short selling of shares listed on UK markets and includes provisions on disclosure to the FCA and the public, a ban on naked short selling, and emergency powers for the FCA .What is an example of a short position? ›
An Example of a Short Position
You borrow 100 shares of the Widget Company from an investment firm and sell them to another investor for $100 a share (a total of $10,000). The company reports its earnings the next week.
This is the opposite of a traditional long position where an investor hopes to profit from rising prices. There is no time limit on how long a short sale can or cannot be open for. Thus, a short sale is, by default, held indefinitely.Can you lose money shorting a stock? ›
Unfortunately, it is easy to lose more money than you invest when you are shorting a stock, or any other security, for that matter. In fact, there is no limit to the amount of money you can lose in a short sale (in theory).Can you short sell with no money? ›
Short selling can only be done with a margin account set up with a broker that must have 100% of the short sale proceeds plus another 50% of the short sale value in the margin account.What is the risk to a short seller? ›
Short selling means selling stocks you've borrowed, aiming to buy them back later for less money. Traders often look to short-selling as a means of profiting on short-term declines in shares. The big risk of short selling is that you guess wrong and the stock rises, causing infinite losses.Is short selling a good idea? ›
Short selling provides benefits to individual investors as well as to the market as a whole. Profit on a stock's decline: Short selling allows investors to profit on the decline of a stock. It provides another tool in an investor's toolkit, allowing investors to make money when they discover an overvalued stock.Why does short selling hurt a stock? ›
It is widely agreed that excessive short sale activity can cause sudden price declines, which can undermine investor confidence, depress the market value of a company's shares and make it more difficult for that company to raise capital, expand and create jobs.