Advertiser Disclosure

A Beginner's Guide to Short Selling

A Beginner's Guide to Short Selling
Chris Muller
Updated August 30, 2021
8 Min Read

Short selling is a form of trading that can be used to profit from market declines. In this guide, I will discuss what short selling is, how it works, and its risks. Short selling may not be for everyone, but it does have some benefits in certain situations, which are discussed here.

What Is Short Selling in the Stock Market?

Short selling in the stock market is when a person sells shares of stock that they don't own. This type of trading is different from the more common buy-and-hold or long-term investing strategy.

Short selling works like this: you borrow stocks and then sell them on the market, hoping to purchase those same stocks later at a lower price to return them to their rightful owner while keeping the difference as profit for yourself (minus any transaction fees).

For example, if you believe prices will go down soon, you may want to short sell a company.

Short selling has been around for centuries, and it's a way to make money in downturns or down markets, but the risks are high. Investors should only short sell stock during down markets as long-term investments - where values are low enough so that any potential losses could be easily made back within one or two days of trading.

What Is the Purpose of Short Selling?

There are many reasons why someone might want to short sell a stock, but there's generally no single motivation; instead, it can be used by investors with various goals depending on where they're coming from and what they think will happen in the future.

In most cases, though, the purpose of short selling is to profit from the downturn in stocks. 

Short selling is risky because you borrow shares of stock from your broker for an indefinite amount of time. If things don't go well with your short sale, then there will be unlimited losses.

What's more, while this money may not have been taken out yet or sent back into your account, it still counts against any other margin limits that exist, so you're allowing yourself access to fewer funds than before.

How Do You Borrow a Stock to Short Sell?

To borrow a stock to short sell, you'll need to have margin privileges on your account.

Once an order is placed, the broker will then borrow the stock and sell it at current market prices in a process called "shorting." When this happens, your proceeds from any short sale are credited into your trading account and become available for trading immediately.

The stocks that were borrowed (from another customer) must be returned by a specified date so they can be re-lent to other investors who want to buy shares of that company's stock.

For example, if you short-sold 100 shares of Google at $600 per share on Monday morning with an agreement that you'd repurchase them at $400 by Friday afternoon, then your profit would be calculated as follows: ($100) * (100 shares). 

This is because if the price of Google drops below $600 from its opening price of $700 throughout Tuesday and Wednesday, then investors who want to get out can sell their stocks at these lower prices since they have not borrowed any stock yet. 

Another more straightforward way of explaining this is to compare it to a long position in a stock.

Long-term Investing vs Short Selling

Here's the difference between long-term investing and short selling:

Long-term investing is when you buy stocks or other securities to hold them indefinitely, without worrying about what happens to their price.

The goal for this type of investor is generally either making money through dividends from shares they own in an open position (e.g., if they own stock) or by watching as their assets increase in value over time due to inflation or market growth;

Short selling is different than buying stocks to hold onto them because it works like this:

You borrow stocks then sell them on the market while hoping to purchase those same stocks later at a lower price so that you can quickly close the transaction and pocket the difference.

Suppose you don't buy those stocks at a lower price. In that case, the investor has to keep them for approximately 160 days or until they can find someone else who is willing to purchase them from him/her (or he/she will have to sell it in what's called an "open position").

How Does Short Selling Work?

As I explained above, short selling is done by borrowing stocks and selling them on the market. When you sell those borrowed shares, your broker then finds someone willing to lend their shares to you.

The process of borrowing these shares can work in two ways:

  1. The investor borrows a certain number of shares from his/her brokerage firm for an amount of time (known as the "shorting period") that they specify when initiating short sale trades.
  2. Alternatively, investors may also have brokers find another trader who wishes to cover their position—meaning buying back what was sold at a higher price than it's worth now. In other words, there are always buyers out there ready to buy up this stock if they think it'll rise again over time due to inflation or other market forces.

This process works because the investor's short sale trades are guaranteed by shares that they do have or can borrow from someone else temporarily (known as "covering their shorts" when they think it'll rise again over time due to inflation or other market forces).

The borrowed shares act like the collateral for what is being sold; if there were an open order at this point for someone who wanted to buy these same stocks, then you would receive some of those proceeds in return.

And finally, one caveat: your broker will require you to keep enough cash available in your account ($0-$25) to cover any potential losses if things don't go well with your bet (i.e., if the stock doesn't go down, but instead goes up).

Short Selling Risks

There are obvious risks to short selling, as there are with any investment. 

The significant risk is that the price of a stock rises, and you get stuck with an asset worth more than what you paid for it (which means your losses will be higher than expected).

There's also the possibility that the market won't move or react in either direction at all while you're holding on to those shares—known as being "flat."

This can happen because few people trade stocks during certain hours, so when they wake up, nothing has changed. However, whatever decision was made overnight still stands until someone else decides otherwise.

Lastly, if interest rates increase, then this decreases demand for everything, and shorts suffer disproportionately. It happens over time; some traders try to short-sell based on their prediction, but this is risky.

Costs of Short Selling

Depending on how you look at it, there are several costs to short selling. The first is that you need to borrow shares of stock from someone else, which will incur interest. 

You also have to pay the dividend on those borrowed shares while they're in your possession and then return them at some point—hopefully for less than what you paid (so it's assumed there'll be an upward trend).

The other costs are taxes: if short-selling, buying, or selling stocks within 30 days of purchasing the same security can result in wash sale treatment.

This means this tax event could cancel out any loss, so keep track! Of course, it doesn't happen with every trade but worth noting when considering trading frequency.

Lastly, using margin can increase losses significantly if margins are not set correctly because the broker may require more collateral to maintain the trade.

In the end, short-selling is a risky endeavor, so start by making sure you have an accurate assessment of how much time and money you want to devote to trading stocks before jumping in!

Short Selling Metrics

There are specific metrics you should look at when short-selling stocks.

The short interest ratio

The short interest ratio measures how many shares are currently being "shorted" versus the total number of shares available to be shorted.

Days-to-cover rate

The days-to-cover rate is a measure used by investors and financial professionals that tells you how long it would take for all shorts in the market to buy back stock they have sold without causing an uptick, which happens when traders bid up prices because there is less supply than demand.

The shorter this period, the more volatile and riskier a company's share price may become as speculators act on any news related to the company or industry sector.

Historical volatility levels/spreads

You can also look at historical volatility levels/spreads regarding other companies within the same general industry or based upon similar metrics like revenue per share.

Average daily volume

Finally, one of the more overlooked metrics when short selling stock is the "average daily volume," which is the number of shares traded in a company's stock on an average day.

Average daily volume is practical when short selling because it provides a sense of the liquidity in that company's stock.

Reasons to Go Short

There are a plethora of reasons to go short on a stock. Probably more than I can mention here. Plus, it's all going to depend on your financial position, insight, and risk tolerance.

That said, here are some of the key reasons you'd want to short sell stock:

  • You believe the company's share price will go down.
  • The company is in a declining industry, and you want to get out of that sector as quickly as possible.
  • You find a company with a low share price relative to the potential and want to buy more shares.
  • You believe there is an upcoming event that will negatively affect the company's stock. For example, you think that in two months, the political environment may change, so you're betting on it now by short-selling stocks with high volumes of trading before anything happens.

The below are some reasons you may NOT want to short sell stock:

  • The market has been volatile, and your timing in entering the trade could result in heavy losses.
  • There has been no significant news about the company (e.g., acquisition), which would have affected its share price. It was an unplanned trade because there was an emergency with personal finances or other investments that resulted in selling shares they didn't own yet.

Why Is Short Selling Bad?

Short selling can be profitable (as long as you're comfortable with the risks and know what you're doing). However, there are times when short selling is just a bad idea. 

For example, if the company's shares are currently expensive, you'll likely lose money if they go down. On the other hand, if there is no significant change in either the share price or news related to the stock, your short sale will fail, and you could end up owing more on that trade than it was worth when you began!

It can also be a bad idea when companies have been doing well lately, but then some new information comes out, which may cause them to falter.

For example, let's say Company A has seen their share prices increase from $50/share last week to $60 this week as investors anticipate an upcoming event with positive results.

Without knowing what those results would be yet, a negative announcement might make people think twice about continually investing in Company A, ultimately leading to the share price going down.

So, is it a good idea to short sell? It can be! But you have to understand how it works and knows that there are risks involved - just like any other investment opportunity.

When I mention "risks," one type of risk would be called volatility – or the changes in the stock's value over time due to things such as supply and demand for shares, change in national economic markers (ex: Gross Domestic Product), etc.

This can make investors feel more comfortable buying a cheaper stock now because they may not want to wait out those fluctuations before making their purchase.

The opposite end of this spectrum might involve heavy competition among investors bidding up prices on stocks with limited inventory available.

Summary

Short selling stocks can be a great idea if you know what you're doing. If not, it can lead to some pretty hefty losses!

I recommend that before taking the plunge and shorting any stock, make sure to understand all of the risks involved, how to time your short sell appropriately (and when NOT to), as well as understanding how this process works in general.

The last thing we want is for someone who doesn't fully understand what they're getting into losing money unnecessarily.

So if you've been considering dipping your toes into the world of short selling but don't feel like bearing all of those risks yourself, there are other ways for you to invest with less danger involved.

Learn how short selling works and the risks associated with this type of trading. Read about what to do before you can start short selling stocks, where you can do it.

0.106.525