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Short selling is one of the most controversial and possibly underappreciated approaches to trading as it involves betting against the success of a given company or financial instrument.
However, short-sellers play an important role in promoting transparency in the financial markets. They also help accurate price financial instruments.
If you are not familiar with what this activity is and how you can engage in it, the following article explains the basics of short selling, how it works, and how you can use your brokerage account to open a short position.
What Is Short Selling?
Short selling involves borrowing a certain financial instrument (e.g. stock, ETF, REIT, etc.) from a brokerage firm to sell it with the expectation that the price of the security will decline in the future. If the price drops as expected, the short seller will earn a profit by buying the instrument at a lower price to close the position.
Short selling can only be done with a margin account. Margin accounts are offered by brokers for investors to borrow money to buy or sell securities at their discretion. These margin accounts generate an interest expense on the amount borrowed.
Here’s an example of how short selling works in practice. Let’s say you believe that the price of Microsoft (NASDAQ: MSFT) shares will decline upon assessing the price action or fundamentals of the stock.
In that case, you can short sell an MSFT share by borrowing one at its current price of $308.26 with the expectation of buying it back at a lower price in the future to close your open position. During the period you hold the MSFT share, you will be paying daily interest on those $308.26 based on your broker’s margin interest rate.
Pro Tip: In a nutshell, short selling is an investment strategy used by investors where they borrow a security from a broker and sell it on the open market, planning to buy it back later for less money for a profit.
Why Short a Stock?
Same as with long positions, the main purpose of shorting a stock is to turn a profit. Some traders follow long/short strategies while others may specialize in short selling only. In any case, the purpose is to rake in gains.
On the other hand, the following are a few reasons why someone may decide to take a short position in a financial asset:
Bearish Price Action
Traders use technical analysis tools to determine the direction that a certain financial instrument may take in the future by assessing factors including its historical price swings and trading volumes.
If a financial asset is displaying bearish signals, a trader may decide to short sell the instrument with the expectation that its price will decline in the future. Some of the most popular bearish price action formations include the head and shoulders, inverse cup and handle, and rising wedge patterns.
Companies that are struggling to remain solvent or whose business model is starting to show signs of becoming outdated or no longer feasible may also be a common target of short-sellers.
Moreover, certain investment funds focus on scanning the market to identify fraudulent companies to expose them and gain from the decline that their stock will experience after these allegations have been proven.
One example of this is Hindenburg Research, a firm that focuses on short-selling stocks of businesses that they have exposed as fraudulent. The Nikola Corporation (NASDAQ: NKLA) was one of its most recent targets amid allegations that its founder, Trevor Milton, who is now being charged with multiple counts of fraud, defrauded investors by making unsubstantiated claims about the firm’s technology and advances.
Certain news and developments may negatively impact the price of a security and that is another opportunity for short sellers to turn a profit. One example of this is lawsuits and investigations opened by authorities against a corporation.
The legal expenses resulting from these proceedings, reputational damage, and other similar costs typically weigh on the price of the stock and short-sellers can profit from a decline if they expect that the news will result in a sustained downtrend for the instrument.
Short sellers can also open positions based on how certain macroeconomic variables are performing. For example, an increase in interest rates will typically result in lower share prices. If a trader is sure that interest rates will rise in the near future, he may decide to take a short position in certain instruments whose price may decline as a result of a change of this macroeconomic variable.
How Does Shorting a Stock Work?
Now that you know what short selling is and why it is an attractive activity for some traders, the following is a step-by-step guide on how you can take a short position on a given instrument.
Step 1: Open a Margin Account
The first step to becoming a short seller is to open a margin account with a brokerage firm. Margin accounts are different than regular accounts as they allow the investor to borrow money from the broker — which is necessary to open a short position.
Opening a margin account is not difficult at all but there are some minimum requirements that brokers typically impose, including having a minimum account balance — usually of $2,000 or higher.
Keep in mind that margin accounts will demand that the investor maintains a minimum maintenance margin. If the balance of the account drops below this figure, the trader could receive a margin call. Margin calls are a warning from your broker. If the trader fails to deposit money to the account, some of his/her existing holdings might be liquidated to increase the account’s equity above the minimum threshold.
The maintenance margin set by the US Financial Industry Regulatory Authority (FINRA) is 25%, although it can be higher for certain specific instruments.
Step 2: Find the Stock You Want to Short
After you open your margin account, you can now select the stock you would like to short. You can find them by using their ticker symbol. During times of extreme volatility, some instruments may be categorized as “hard to borrow.” In those cases, traders will be charged an additional daily stock borrow fee.
Step 3: Place Your Order
To open a short position, traders must select the “Short” or “Short Sell” option that is typically displayed in the online trade order ticket. The system will prompt the trader to indicate how many shares will be shorted and it will also indicate the bid price for the instrument. This is the price at which the stock will be sold.
Step 4: Wait for the Stock to Decline
Now that the short position is open, the trader has to wait patiently until the instrument experiences the expected decline. If this decline occurs, the trader will experience a gain. Meanwhile, if the price increases, the trader will experience a loss.
Step 5: Buy the Stock and Close Your Position
Once the price of the security reaches the exit target — a price at which the trader feels comfortable enough to close his position — a buy order has to be placed to repay the borrowed shares.
Once the order is executed, the trader will no longer pay interest or fees on the borrowed stocks.
Short Selling Example
A fictitious example of short selling would be something like this: Let’s say you borrow 100 shares of a company (ABC) and immediately sell them on the stock market for $100 each, generating $10,000. If the price of the stock drops to $50 per share, you could use your $10,000 to buy back all 100 shares for only $5,000, then return the shares to the broker. Your position on (ABC) netted you $5,000 (minus any commissions, fees, and interest).
A good real example of a recent short selling opportunity was the decline that shares of multiple Chinese companies experienced due to the government’s hostile actions against big corporations within the country.
The government’s actions fall into the category discussed above in regards to macroeconomic changes that can affect the price of an individual stock. Shares of Alibaba (NYSE: BABA), for example, traded 54% below their 52-week high in September 2021.
A short seller could have borrowed and sold shares of Alibaba at any given point between October 2020 and July 2021 and bought them back weeks or months after at a lower price. The positive difference between the selling price and the buying price in this operation would be kept by the trader.
Cost Associated with Short Selling
Short selling can be expensive depending on the stock you decide to short and how much your broker charges. The following are the three more common costs you will have to bear if you decide to keep a short position open for a while.
- Interest rate: All brokers charge an interest rate for lending money via stock borrowings. The rate is expressed on an annual basis but it is calculated per day for your borrowed funds and deducted from your account balance at the end of every month. Robinhood, for example, charges a margin rate of 5% per year. Meanwhile, the rate you pay may vary depending on the size of the loan. Larger loans tend to enjoy a lower rate.
- Borrowing fees: When a stock becomes “hard to borrow,” brokers can charge a daily fee for short selling the issue. Hard-to-borrow fees vary from one broker to the other and they are typically expressed in percentage terms and calculated in the same way as interest charges.
- Dividends: When you borrow a stock, any dividends the broker would have received for holding the stock must be paid and they will be deducted from your account balance on the payment date. This cost can dramatically reduce the returns earned on the short sale and traders should ensure that they are either willing to pay these dividends without significantly hurting the potential profitability of the transaction or by short selling the issue after the ex-dividend date.
Advantages of Shorting a Stock (Pros)
- Attractive gains can be made if the trader’s directional forecast is correct.
- Short selling increases the transparency and efficient pricing of the financial markets.
- It is a good incentive for firms whose business involves revealing fraudulent publicly-listed businesses.
Disadvantages of Shorting a Stock (Cons)
- It can be expensive and fees can eat up a large chunk of the profits.
- Short selling, by nature, goes against the natural long-term trend of the US stock market, which is upwards. That reduces the odds of turning a profit.
Frequently Asked Questions on Short Selling
The following are some of the most frequently asked questions we get on the topic of short selling.
What Is the Opposite of Shorting a Stock?
The opposite of short selling a stock is taking a long position, which means that the trader is betting that the price of the instrument will rise in the future.
How Long Can I Short a Stock For?
There is no limit to the number of days during which a trader can keep a short position open. However, if the instrument rises in value to a point that the minimum maintenance margin of the account is trespassed, the broker may decide to liquidate the position to cover the loaned amount. This event is known as a margin call.
What Is a Short Squeeze?
A short-squeeze occurs when a heavily shorted financial asset experiences an unexpected and rapid increase in its price. As a result of this uptrend, short sellers will rush to cover their open positions by buying the instrument and that often pushes the price even higher. Short-squeezes are, to some extent, a reinforcing loop until all short-sellers have fully covered their positions and new short positions are opened at the now higher price.
Can Shorting a Stock Bring Its Value Down?
Influencing the price of an instrument can only be achieved by buying or short selling significant volumes — usually larger than the daily average. Institutions, hedge funds, and deep-pocketed speculators may cause a large drop in the price of a security if they decide to take a large short position as buyers will progressively bid down the stock once they notice this elevated selling volume.
In summary, yes, shorting can drive the price of a financial asset down but only if the number of shares sold is large enough to move the needle.
What Happens If the Stock Price Rises?
If the stock price of a shorted instrument increases during the time the trader has borrowed the instrument, a loss will be incurred.
When Does Short Selling Make Sense?
There are multiple scenarios in which short selling can result in a profitable transaction. News that have a negative material effect on a company’s future financial performance, deteriorating fundamentals, and bearish technical setups are some of the instances in which short-selling might make sense.
Pro Tip: Keep in mind that the practice of short selling has a high risk/reward ratio, which means that while you can enjoy big profits, you can also lose a lot of money.
Now that you know what short selling is and how you can profit from it, do you think this is an approach that fits your investing methodology? Are you willing to bet on the decline of a financial instrument?
If you would like to keep learning about how to profitably short sell stocks you should develop a system through which you can identify potential short selling opportunities based on a set of objective variables that indicate either the existence of a bearish price action pattern or that a negative change in the business’s fundamentals has occurred.
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Alejandro is a financial writer with 7 years of experience in financial management and financial analysis. He writes technical content about economics, finance, investments, and real estate and has also assisted financial businesses in building their digital marketing strategy. His favorite topics are value investing and financial analysis.