Everything You Need To Know About Shorting A Stock

Everything You Need To Know About Shorting A Stock

Everything You Need To Know About Shorting A Stock
Reading Time: 5 minutes

You’ve probably heard of a well-known practice on Wall Street that recently entered the mainstream.

Short selling, also known as shorting a stock, has taken the world of retail investment by storm. While short selling was once a relatively unknown investment activity that only financial experts practiced, we’re now seeing thousands of everyday investors (often referred to as retail investors) engaging in the age-old strategy.

Like every other investment strategy, short selling is risky and you should do extensive planning and research before getting into it. But where should you start?

In this article, we’ll help you understand the basics of short selling. We’ll talk about what it means to short a stock, how it works, and the advantages, disadvantages, and risks of doing so. We close by discussing why you should care about short selling.

What Is Shorting A Stock And How Do You Do It?

While there are quite a few steps in the process of shorting a stock, the fundamental principle behind it is relatively simple.

If you think that the price of a company’s stock is going to decline in the near future, you borrow its shares from someone who owns them (mostly through a brokerage company), sell the borrowed shares to investors willing to buy them at the market price, and keep the profits.

Simple enough, right? Well, that’s only the beginning.

As you know, when you borrow something, you always have to return it. Likewise, you have to return the shares that you borrowed through the brokerage company. This is where we enter the most crucial phase of a short sale that determines whether you execute it successfully or end up losing money.

Specifically, the key to success is that the shares have to decline in value by the time you have to buy back and return the ones you borrowed. Let’s walk through a simple example to illustrate this point.

You’ve done your homework, run the numbers, and are certain that the stock of the fictional company Neverland will drop significantly in the next few months. You borrow 10 shares at $20/share and sell them at the same price. You now have $200 in profit. But you still owe the brokerage for the 10 shares that you borrowed from them.

Thankfully, your guess was spot on and Neverland’s stock plummeted to $10/share. You use the profits from the initial sale to buy 10 shares of Neverland for a total cost of $100. Finally, you return these shares to the brokerage and keep the $100 that is remaining ($200 minus $100).

Congratulations, you just made $100 in profit from a short sale!

When Might You Think Of Shorting A Stock?

You might consider shorting a stock if you’re certain that a company’s stock is overvalued and the company is headed for bad times.

For example, maybe you’ve extensively studied the company’s financial records and realize its business is so unstable and risky that it will soon experience a downturn. These hardships will cause its stock price to plummet, so you might as well profit from their economic demise while you can by shorting their stock.

Or, maybe you understand the company’s products better than anyone else and realize that, contrary to popular belief, they are terrible products that are all hype and no substance. The company will soon be found out and its stock price will go down, making it an ideal candidate for a short sale.

Lastly, rather than an individual company being at fault, it might be that you expect a significant economic downturn to be on the horizon and that an entire industry will collapse.

One of the most famous examples of this in recent history was during the Great Recession of 2007–2009. A group of hedge fund managers saw the crisis coming, shorted the entire housing industry and financial sector, and walked away with millions of dollars in profit. 

Michael Lewis portrayed their story in his best-selling book The Big Short: Inside the Doomsday Machine. His book was later turned into the brilliant award-winning movie The Big Short

What Are The Advantages And Disadvantages Of Shorting A Stock?

The main benefit of short selling is that it allows you to quickly profit from a company’s demise when you clearly see it coming. Short selling can also be beneficial to the market as a whole, as short-sellers often bring new information to light that can help quiet unjustified hype about a company’s prospects.

This can result in keeping a stock at a lower and more realistic price than it would have been if only the yes-men were allowed to raise their voices. Short-sellers keep companies in check and often help uncover poorly run or overvalued businesses.

Another advantage of short selling is that by allowing traders to borrow shares, it gives them access to instruments that they would otherwise not be able to trade. If you want to benefit from the decline in the price of a stock, you can do so without owning it.

However, a key disadvantage of shorting a stock is that the fees for the activity can accumulate very quickly. You have to pay a brokerage fee, interest fees for borrowing the shares, and, depending on the brokerage, also a commission fee. If you’re shorting a stock that pays dividends, you’re responsible for making sure the original investor you borrowed the shares from receives their dividend payments.

What Are The Risks Of Shorting A Stock?

The greatest risk of short selling is that the potential loss of the activity is unlimited. Going back to the Neverland example discussed earlier, let’s say that you bet wrongly and after selling the stocks you borrowed, Neverland’s stock increases to $2,000/share. 

Remember, you owe the brokerage 10 shares (i.e., $20,000 worth of shares) and have only $200 in profit, meaning that you have to somehow obtain $19,800 ($20,000 minus $200) to buy back and return the shares that you owe the brokerage. Now imagine if the shares rose to $50,000/share instead of $20,000. Your loss would be even greater.

The greater the rise in the share price, the greater your loss on the short sale. The problem is that the price of a share can, in theory, rise to infinity, meaning that your potential loss can theoretically be infinity.

Should You Consider Shorting A Stock?

As the name inadvertently suggests, short selling is best implemented as a short-term strategy rather than a long-term one. Given that you have to return the shares that you borrow within a short period of time, you’re forced to only focus on the short-term characteristics of a company rather than the long-term ones. On the contrary, regular investing forces investors to be concerned about the long-term fundamentals of the company and market.

Another issue to consider is that even if countless retail investors are trying to short stocks today, it’s really only something you should do if you are a highly experienced investor. Though the principle behind it is quite simple, short selling is a fine art that requires a lot of practice and insight to do well. It can easily go wrong and result in the loss of thousands, or in worse cases, millions of dollars. Hence, you should only consider short selling as a potential addition to your overall investment strategy if you’re an experienced investor.

Lastly, you have to think about whether short selling aligns with your financial goals, vision, and plan for the future. If your plan is to have a net worth of $100,000 in five years, save $200,000 for your kids’ college education before they graduate high school, or retire before your 55th birthday, you have to think about whether short selling is the best investment strategy out of all the ones that are available to help you achieve your personal and financial goals.

Why Should You Care?

Now that you know what short selling is, how to do it, its advantages, disadvantages, and risks, and whether you should consider shorting a stock, you’re probably wondering why we didn’t answer what is arguably the most important question of them all: why should you care?

You should care about short selling because investing should be (if it isn’t already) one of the most important components of your financial plan. Given that there are many different forms of investing, it’s crucial that you assess each one and understand which is best for you based on your age, phase of life, goals, and degree of comfort with risk. 

Short selling isn’t a bad strategy and it isn’t a good strategy—it’s just another option that investors have available to them. Whether you decide to use it to achieve your financial goals is completely up to you.

The takeaway is that no matter what you do, always make an informed decision when it comes to spending or investing your hard-earned money.

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