Short selling, or shorting a company’s stock, is a short-term practice (think days to weeks) that involves speculating on a stock’s future performance for your financial gain. Even if you’ve never invested before, you’ve probably heard the term – but if you’re not familiar with the industry, the concept can be more than a little confusing.
That’s why we’re here to break it down.
- Shorting a company’s stock involves borrowing shares on margin, selling them to another investor, and (hopefully) rebuying them at a lower price. The difference in price is your profit – or your loss.
- A speculative investor may sell short because their analysis says the company is overvalued, whereas a hedging investor may sell short to offset risk in other similar investments.
- Short selling is risky because it comes with unlimited downside: if the stock price increases, there’s no limit to how much money you could owe your broker. But if you make the right call at the right time, there’s plenty of profit to be had, too.
- Short selling often comes with a bad reputation due to unscrupulous speculators who use manipulation tactics to artificially influence stock prices. However, most short sellers do so to make money or hedge against risk.
What Does “Shorting a Company’s Stock” Mean?
In the simplest possible terms, shorting a company’s stock involves borrowing shares from a broker, selling them to another investor, and (hopefully) rebuying the shares at a lower price to return to your broker.
Let’s give an example.
Say that NotAmazon, a massive brick-and-mortar retailer, is currently trading for $100 per share – but you suspect that their shares are overpriced. So, you borrow ten shares from your broker and sell them to your best friend – who is stubbornly bullish on NotAmazon – for $1,000.
Thanks to your excellent research and judgment, you happen to time the market just right, and the stock falls the next day to $75 per share. Using the money you got from your best friend, you rebuy all ten shares for $750 and return them to your broker – and pocket the $250 difference.
Of course, your best friend is now annoyed that you made a better investment call, but what can you do
The Downsides of Short Selling
Short selling a company’s stock is a great way to make quick cash if you make the right call. However, it’s a risky strategy with limitless downside risk. That is, if the stock’s price increases, there’s no limit to how much money you could potentially owe your broker to cover your borrowed shares.
For instance, in our example above, the stock dropped from $100 to $75 per share, netting a hefty $250 profit. But if the stock had increased to $200 instead, you would have to shell out $2,000 for the same number of shares, leaving you $1,000 in the hole.
And while a $100 jump in a stock’s price is improbable, it’s not impossible – and therein lies the risk.
Additionally, shorting stocks requires a method of investing known as margin trading. When you trade on margin, you open a margin account with your broker, which allows you to borrow money with your investment serving as collateral.
Unfortunately, margin trading can be expensive, and there are rules you have to follow.
For instance, federal regulations require a minimum maintenance balance of 25%. If you slip below this line, the broker may put in a margin call and require you to front more cash or sell your position. And in the meantime, the broker may earn interest on your margin account or demand commissions on your trade, thereby eating into your profits.
A Real-World Example
Of course, there’s one poignant, real-world example of why short selling can be risky: The Wall Street Bets controversy.
If you followed the news this year, you’re probably familiar with the wild “short squeeze” stemming from the Reddit forum WallStreetBets. In a nutshell, the community – upon hearing that several prominent hedge funds had taken the short position on out-of-date companies like GameStop and AMC – snapped up stocks to drive up share prices.
As a result, any hedge funds that didn’t vacate their positions immediately took massive losses – some even to the point of bankruptcy. At the same time, retail investors who hopped on early and sold out at the right time enjoyed massive profits before prices fell significantly.
So, Why Do People Short a Company’s Stock?
While short selling can be risky, there are some circumstances under which shorting a company’s stock may make sense.
For instance, if you’re convinced a company is about to take a short-term drop, such as can follow a dismal quarterly earnings report or court ruling, you may decide to make money on a company’s misfortune for your own gain – even if the company is otherwise a solid investment.
Plus, shorting can provide a way to diversify your investment exposure and boost your returns. Whereas your stock returns are limited by a company’s stock growth, shorting returns give you a chance to profit off their losses, as well.
Some retail investors – though more often portfolio managers and institutional investors – also use short selling as a way to hedge against the downside risk of a long position in the same or related securities. Hedging involves taking an offsetting position to reduce risk exposure and is considered less risky than taking a purely speculative position.
But ultimately, retail investors short sell because the strategy offsets enormous risk with the chance for high-yield rewards. The return on investment (ROI), especially with the use of a margin, provides a potentially inexpensive method to hedge against risks while seeking greater, more immediate profits than long positions.
The Ethics of Shorting Stocks
Short selling comes with a bit of a bad reputation, and those who engage in short selling may be criticized as callous, ruthless, money-grubbing, or other not-so-nice monikers.
This is due in large part to the actions of unethical speculators who use short selling and derivatives to artificially deflate prices. Such illegal practices – known as “bear raids” – are often accompanied by spreading damaging rumors about companies in vulnerable positions. By engaging in market manipulation, the organizers of bear raids hope to seek astronomical profits on their short positions.
Though bear raids are illegal in the U.S., they do happen occasionally. However, they don’t account for the majority of short sellers – most of whom are taking short positions to make an honest buck on a hunch or hedge against other risks.
And while short selling may seem detrimental, the practice can benefit the market by:
- Providing liquidity – particularly in the form of more buyers and sellers
- Preventing bad stocks from becoming overvalued by curbing excessive optimism
- Offering a legitimate source of data on market sentiment and demand
Short selling can even uncover financial fraud, in a roundabout way. While the action of short selling itself does little for fraud investigation, the research behind a dedicated investors’ decisions can shed light on hidden practices, such as falsely inflated balance sheets, that may be of interest to the SEC, IRS, and other investors.
Stock Shorting vs Traditional Gambling: What’s the Difference?
If you Google “what is short selling?” it’s likely that you’ll come up with several results that refer to the practice as a form of betting or gambling against a company.
And while the mechanics and outcomes of investing are more complex – and arguably ethical – than gambling, there are some significant similarities between shorting stock and betting on, say, the outcome of a poker game.
That is to say, you’re gambling money that the outcome of an action or situation will favor your interests (and line your pocket in the process).
However, there’s also an important difference between shorting and gambling: the absence of random chance.
Gambling, betting, whatever you call it, often involves an element of random chance. Yes, there’s potential for any particular card shark to beat the odds and win against the house. But assuming that the dealer isn’t playing dirty, it’s all down to the shuffle of the cards (and a little bit of acting ability).
But with shorting stocks, while there’s an element of chance – as in, there’s a chance you might be wrong – there’s often also a lot of research and analysis underlying your decision.
Whether you think a company is about to post abysmal quarterly results, incur a massive judgment against them, or fall because their fundamentals say they’re overpriced, a good short seller uses data to support their theories.
Of course, that doesn’t mean that your theory can’t be wrong. But it does mean that chance is not the primary executor of your success.
How to Make Money Shorting Stocks
There are a few ways to make money by shorting the market, each with their pros and cons.
The first, of course, is to borrow shares from a broker, sell them to your best friend, and hope that the company slips up. However, since this method comes with unlimited downside risk, it’s typically not recommended for the average investor. Plus, you’ll need to accurately judge the timing, technical indicators, and future valuation to be successful.
Investing in Inverse Funds
For retail investors, one of the easiest methods is to invest in “inverse funds.” These ETFs and mutual funds are pegged to an index, such as the S&P 500. But they only profit when the underlying index declines – and when the market goes up, they lose value.
Inverse funds, often called bear funds, are built around counter-cyclical assets and underlying short sales. Since they don’t tit-for-tat match the S&P 500’s performance, they tend to drift more than standard index funds. But because you own the assets, there’s less risk than short selling yourself.
Shorting Exchange-Traded Funds
You can also short sell an ETF instead of a specific stock. This strategy involves taking the short position on an ETF indexed to the S&P 500. In other words, you’re betting that the entire market will fall, not just one stock or industry. Then, when the broader index declines, your short position will profit.
Short selling ETFs is often less risky than shorting individual stocks for individual investors, as there’s more wiggle room for the market to move downward. However, that doesn’t mean your risk is nonexistent.
Taking the Put Option
Alternatively, you may decide to minimize your risk – particularly your downside exposure – by buying a put option on a stock. This gives you the right, but not the obligation, to sell a position at a predetermined price (strike price) before your options contract expires.
For instance, if you buy a put option at $100, and the stock drops to $75, you can buy ten shares at $75 apiece and sell them for $100. This nets you a guaranteed $25 per stock, providing another way to profit off a stock’s misfortune – without risking your own.
Stock Shorting Isn’t for Everyone
Regardless of which method you’re comfortable with, stock shorting isn’t an investment strategy for everyone. There’s no guarantee that you’ll make the right call, on the right company, at the right time. Not to mention, the potential downsides are endless – while your upside is capped at a stock dropping to $0.