Read This Before Shorting a Stock

The ability to sell stocks short is the basis of hedging a long portfolio, it’s also the basis for my swing trading approach to the markets. This post by SoFi explains more about shorting. Tim

It’s possible to make money in the market no matter which way it moves—up, down, or sideways.

For new investors, betting on a move down may sound strange. The more traditional way to profit in financial markets is a buy-and-hold strategy: purchasing a security, holding it, selling it on a later date for a higher price.

However, of course, not all assets climb higher.

So what do investors do when they’re reasonably certain that a particular stock or industry will be trending lower? Shorting a stock, also known as short selling, is one way to potentially profit from a downward move. This strategy is popular among savvy, risk-tolerant investors who may have a knack for market research and predicting trends.

Read on to learn more details, including:

•  What it means to short a stock
•  Why people might be interested in shorting stocks
•  How shorting a stock works
•  Specific ways to sell stocks short

What Is Shorting a Stock?

Shorting a stock is a way for investors to make a bet that the future share price of a particular stock will be lower than its current price. There are multiple ways this can be accomplished. For now, we’ll focus on margin trading.

Margin accounts are brokerage accounts that are required by the federal government to regulate broker lending to investors. To short a stock, an individual first borrows shares from a brokerage firm that currently holds a position in the stock.

Then, the borrower sells the borrowed shares on the open market to another investor, with the plan that when the stock price drops, the borrower will buy back the same number of shares they borrowed (or more, if they choose), in order to return them to the brokerage firm.

If the share price of the stock declines, the borrower can buy the same shares for less money and pocket the difference. But if the share price increases, the borrower will lose money. They would have to buy the same shares for a higher price.

Example of Shorting a Stock

Here’s a hypothetical case. Let’s say an investor found a company that they think is overvalued. They borrow 100 shares of stock in company A at a price of $10 per share for a total of $1,000 (plus any applicable brokerage fees).
In scenario A, the investor made a prediction that was spot-on and the price falls to $9 per share. Great! Now the investor can buy back 100 shares at a price of $9 for only $900, and the leftover $100 is the profit.

In scenario B, the investor misses the mark, and the price rises to $11 per share. Now they have to buy back 100 shares at a price of $11 for a total of $1,100, for a loss of $100.

Selling a stock short involves significant risk—far surpassing the risk of “going long” on an investment. When holding a stock, there’s a limit to how low a stock can go, and investors can only lose as much as their initial investment. If someone were to buy 10 shares of XYZ company at $10 per share, for example, and the share price goes to zero, they will lose $100. The price can’t go lower than zero, so someone can never lose more than what they had first invested.

However, when someone shorts a stock, they risk infinite losses due to the fact that there is no upward limit on a stock’s share price. As long as the price keeps going up, they will keep losing money.

What Is a Short Squeeze?

A short squeeze refers to the rapid flight of short sellers from stock in order to limit losses–a situation that leads to a dramatic surge in the stock’s price.

Here’s how they typically occur: a sudden increase in the stock price causes investors to scramble to close their short positions by purchasing shares. This results in further gains in the stock, which in turn causes massive “covering” by other short-sellers, bringing about a “squeeze.”

Famous cases include Volkswagen in 2008 after Porsche increased its stake in the German automaker, causing a short squeeze that briefly made Volkswagen the world’s most valuable stock by market cap. Tesla is a volatile stock, which has made it a popular short target in the past couple of years, and dramatic price swings by the electric carmaker’s shares have led to short squeezes.

More recently, in January 2021, the gains in GameStop, a brick-and-mortar video-game retailer, were due to a massive short squeeze after retail investors piled into the stock, which was heavily shorted by hedge funds. Shares of movie-theater operator AMC Entertainment Holdings and retailer Bed Bath & Beyond underwent similar experiences.

Why Is Anyone Interested in Shorting a Stock?

There are three main reasons people might choose to short a stock:

•  The hope of making fast profits
•  Seeking potential returns during a stock market crash
•  As a hedge against long positions

While risky, shorting a stock could be profitable. It’s possible to make a lot of money in a short period of time, as sometimes stocks see rapid, steep declines.

When investing during a recession, for example, sudden drops in the share prices of many stocks across many different industries can occur. While this might cause the portfolios of many investors to decline, others may be profiting because of their short positions.

One reason investors might choose to short a stock is to hedge against their long positions. The term “hedge” is used to refer to an investment that protects against losses in another asset. So in this case, an investor may put on a short position in order to hedge or offset a potential loss in a long position.

Example of Shorting to Hedge

For example, say someone has 100 shares of stock in a company that deals in real estate and is classified as a real estate investment trust (REIT). The investor has researched the company and believes it has sound fundamentals, high-quality management, and will continue to grow.

But, in this hypothetical scenario, there could be cause for concern. An investor won’t know how the real estate market will react to the macroeconomic environment. Maybe they figure there’s a chance that real estate prices could be heading lower in the near term, even though they’re still a believer in the stock they purchased and the industry as a whole.

In this case, investors might consider shorting a stock in the same industry or a related one. To hedge this long position, an investor might decide to take a short position in a different REIT or perhaps an inverse exchange-traded fund (ETF) that provides short exposure to real estate. This way, if the hypothetical REIT loses value, their short position will increase in value, offsetting their losses.

Is Shorting a Stock Wrong?

The practice of short-selling is not without controversy. Shorting may have received a bad rap by being associated with the fear that shady investors will spread malicious rumors about a company in the hopes of influencing its share price.

But this kind of trickery can go both ways. There have also been investors who sought to manipulate the price of a stock upward by spreading bullish rumors that turned out to be false. Such tactics are considered market manipulation and it is illegal. Anyone who gets caught attempting to manipulate markets might be subject to regulatory punishment by the Securities and Exchange Commission (SEC).

Shorting can simply be a way of handling investing risks. For instance, shorting to hedge a position can be a type of investment risk management that helps investors minimize their losses, although doing so will also cap their gains.

How Does Shorting a Stock Work?

Here are some ways investors might establish short positions:

•  Margin accounts
•  Put options
•  Inverse ETFs

Margin Accounts

As mentioned, shorting a stock in the traditional sense most often requires trading on margin, because a margin account offers leverage beyond the existing cash balance of an investor’s brokerage account. Investors might need this credit extension because when shorting a stock, they may lose more money than they invest, receive a margin call, or possibly lose even more than the balance of their entire account.

With a simple cash account, investors can only invest or lose what they have right now. But trading on margin might give someone, say, two times (2x) leverage. Say an investor has $1,000. With a cash account, they can only work with investments that cost $1,000 or less.

But with a margin account that offers 2x leverage, they can trade with up to $2,000. Trading on margin is considered to be very high-risk because it can amplify rewards or losses significantly.

Put Options

If a brokerage account allows investors to trade options, placing put options on stock allows them to profit when it declines in price.

A put option is an options contract with two key features: an expiry date and a strike price. The expiry date is when the contract will be exercised and the strike price is the price at which the contract will be “in the money,” meaning it will net an investor a profit once it passes that price to the downside.

For example, imagine that an investor wants to short an imaginary stock that we’ll call ABC company. Shares of ABC are currently selling for $10. The investor believes the company is overvalued and the stock will soon head to $8 or lower. So, they buy a put option for ABC with a strike price of $8 and an expiry date three months in the future. If ABC stock falls under $8 to $6 during that time, this investor could make money on the put option.

Options contracts could be profitable but risky. Trading them requires more knowledge than trading something like regular stock or ETF. Put options also suffer from something called time decay. Underlying the concept is the fact that as time passes and a put’s expiry date approaches, there is less time for the stock price to go in the direction you expected. As a result, the value of options contracts declines over time.

Inverse ETFs

Inverse ETFs may be the easiest way to put on a short position. Investors can buy shares of an inverse ETF just like they would buy an ordinary stock. These investment vehicles aim to provide returns that are opposite the performance of an underlying index.

It’s important for investors to understand that inverse ETFs are designed to be held and traded during a single trading day. Held for longer, inverse ETFs may not achieve the exact -1x return of the underlying index. That’s because of how returns get compounded.

Let’s look at the S&P 500 Index and a hypothetical inverse ETF that tracks it. The S&P 500 is at 2,000 on a given day, while the inverse ETF is trading at $20 a share. If the benchmark gauge falls 1%, its new level would be 1,980. Meanwhile, the inverse ETF’s price would rise to $20.20, since it’s supposed to move in the opposite direction of the S&P 500.

If the S&P 500 were to rise 2% on the next day, however, the measure would climb to 2,019.60. The total gain over the two days for the equity gauge would be 0.98%. Meanwhile, prices of the inverse ETF would fall to about $19.796 — so a loss of -1.02% over two days.

While the difference between 0.98% and -1.02% appears small, such discrepancies can add up over time, causing the inverse ETF to deliver returns that aren’t the mirror opposite of its underlying index. Therefore, investors should not assume that just because a market falls 5% in a week, its corresponding inverse ETF will rise 5% in that same time period.

The Takeaway

Shorting a stock is when investors bet that the price of a specific stock or ETF will fall. Short sales are often used by investors who are bearish on a specific company or industry. Short positions also help investors mitigate losses during widespread market downturns or hedge losses from another holding.

While shorting can be a useful investment tool, it’s also very risky. That’s because of how there’s no limit to how high a stock can go, meaning that there’s also no limit to the losses a short seller can potentially book. Add to that the risk of a short squeeze–when there’s a massive rush by bearish investors to exit their short positions–and it’s fair to say that shorting can lead to painful losses.

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This post was produced by SoFi and was syndicated by Tim Thomas / Timothy Thomas Limited. 

Featured Image Credit: Unsplash.