How to Short a Stock (or the Entire Stock Market)
You know you can make money from stocks, mutual funds, and exchange-traded funds (ETFs) when the market is strong, but what about when the market is in decline?
What if you could turn a profit during a bear market too?
While it may sound too good to be true, that’s the theory behind short selling -- profit when an investment drops in value.
Learn how short selling works and the pros and cons of shorting the market.
What Does It Mean to Short a Stock?
When you short a stock, you sell borrowed stock at the current price and then close the deal by purchasing stock at a future time.
If the price drops between when you make the agreement and when you deliver the stock, you earn a profit.
But, if the price increases by the time you deliver the stock, you lose money.
Some investors, particularly hedge funds, use short selling for hedging to mitigate losses in their portfolios. It allows them to earn profits in declining or stagnant markets, even though there is a substantial level of risk.
Selling short is primarily a short-term investing strategy for securities that you expect to drop in price.
Short sale example
For example, let’s say that Company X is selling at $100 per share on August 15, but you don’t think that the company will perform well over the next few weeks.
If that’s the case, Company X could be a good choice for short selling.
You would place a short-sell order through your brokerage account.
You could set a market short-sell order to buy 100 shares when the stock is trading at $100.
If the order is filled at that price and the stock price decreases to $90, you would get $1,000 in profits ($10 per share gain times 100 shares) minus your broker account fees and interest.
Ideal for More Advanced Investors
The key to short selling is recognizing which securities are overvalued and may be declining soon, and what price they will reach.
Depending on the securities and your strategy, you may enter and exit a short sale in a single day, or you may hold onto securities for weeks.
Because timing is so pivotal, short selling is typically best for experienced investors.
But even seasoned investors usually utilize limit orders or other trading orders to try and reduce their risk.
How to Short a Stock
With short selling, you don’t actually own the securities. Instead, you borrow shares from someone else.
Typically, you borrow them from a brokerage firm to sell it at the price it’s selling at the time of the transaction.
To engage in short selling, you have to complete the following steps:
1. Open a brokerage account
To short a stock or other security, you need to have a brokerage account with a firm that offers margin accounts.
Margin accounts are a type of brokerage account that allows you to borrow money to purchase different securities, including short sales.
2. Decide on what type of securities you want to short
You can short stocks, exchange-traded funds, and real estate investment trusts (REITs), but not mutual funds. Select which securities you want to purchase.
3. Complete a sell order
Most brokerage firms have an option for “short” sales.
The typical transaction type is "Sell" -- even though you don't own the securities yet.
If your firm doesn’t show a sell transaction type, contact your broker and ask them to process the short sale for you (you may not have been approved for a margin account yet).
4. Complete a buy order to cover your short
Ideally, the securities’ value has declined, and you earned a profit.
However, even if you lose money, you still have to buy the security back and "repay the loan."
To do so, you need to complete a buy order to close out the short sale process.
Risks of Short Selling
While short selling can be profitable, there are some significant drawbacks to keep in mind.
The biggest issue with short selling is that the value of securities could rise, causing you to lose money.
There is technically no ceiling on how much a stock can appreciate, so there is no limit on your potential losses.
If security prices move higher, your account may fall below your brokerage firm’s minimum required value.
When that happens, the brokerage firm may issue a margin call.
If a brokerage firm makes a margin call, you must deposit more money or securities into your account, leaving you scrambling if you’re short on cash.
If a stock price starts to go up, short-sellers may feel pressure to get out quickly before their losses are too great.
As short sellers purchase stock to cover their position, they can drive the stock’s price even higher, leading to what’s known as a short squeeze.
A short squeeze can cause significant losses.
The Uptick Rule was put into place to prevent short selling from driving down the price of stocks that dropped more than 10% in one day compared to the closing price on the previous day.
Because of this rule, short sales must be completed at a higher price than the previous trade, adding restrictions to short selling and your potential profits.
Historically, the stock market tends to trend upward.
Over the long term, most securities will appreciate in value, making short selling a risky investment strategy.
If you are new to investing, it’s best to hold off on short selling until you have more experience.
If you’re looking for more beginner-friendly investment options, consider index funds or managed mutual funds.