Short selling: Betting that a stock’s price will fall and why it can be risky

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Short selling is a way to invest so that you can attempt to profit when the price of a security — such as a stock — declines. Rather than buying a stock (called going long by investors) and then selling later, going short reverses that order. A short seller borrows stock from a broker, sells that into the market and then later hopes to buy back that stock at a cheaper price, profiting on the difference in prices.

Here’s a quick breakdown of how short selling works, how much you can make doing it and what makes it risky.

How shorting works

Short selling, or shorting, a stock or another type of security is straightforward in theory, but it presents different costs and risks from going long. Plus, shorting is sometimes seen as a controversial tactic.

When you short a stock, you’re betting on its decline, and to do so, you effectively sell stock you don’t have into the market. Your broker can lend you this stock if it’s available to borrow. If the stock declines, you can repurchase it and profit on the difference between sell and buy prices.

So going short really only flips the order of your buy-sell transaction into a sell-buy transaction. In other words, instead of “buying low and selling high,” you’re trying to “sell high and buy low.”

But there are a few other wrinkles to short selling that increase its cost relative to going long a security:

  • When you short a stock, you rack up a margin loan for the value of the stock you’ve borrowed. You’ll pay the broker’s rates on margin loans, which may run as high as 10 percent or so annually.
  • Short sellers are also charged a “cost of borrow” for shares they are lent. That may be a charge of just a few percent annually, though on highly popular shorted stocks, it may surge over 20 percent. This fee typically goes into the pocket of your broker, though at least one brokerage (Interactive Brokers) splits that fee with the stock’s owner.
  • If you short a stock that pays a dividend, you’ll also have to pay back any dividends that were paid out during the period when you shorted the stock. That could add another few percent annually to the cost of shorting the stock.

Shorting is sometimes seen as an attack on the stock market, because certain investors see it as betting on failure rather than wagering on success. If you mention short selling to an investor, you’re likely to get one of two responses:

  • “Short sellers provide a valuable service by keeping stocks from running too high and by exposing frauds.”
  • “Short sellers spread false rumors and sow uncertainty in profitable and socially valuable companies for their own profit.”

It’s a stark dichotomy, and while there’s some gray area, it won’t seem like it if you ask investors who have been on the receiving end of a short seller’s attack. Still, both points can hold true.

Short sellers get a bad rap because “they are viewed as betting against the success of a business, and, to many, that is an ‘un-American’ attitude,” says Robert R. Johnson, professor of finance at Creighton University. “Since short sellers succeed when stock prices decline, they are viewed negatively by many, even seen as nefarious.”

Yet short selling can limit the rise of stocks, and prevent them from running into a speculative frenzy, helping the market maintain order. Shorts may also bring to light valuable information about companies that are undertaking fraudulent activity or accounting shenanigans, so that investors as a whole have more complete information and may properly price a company.

And short sellers bring another positive to the market, too, Johnson says. “The most important value of short selling is that it provides markets with a greater degree of liquidity. More investors stand ready to buy and sell,” he says.

On the other hand, some very public short sellers are happy to spread rumors or opinions that try to discredit profitable companies and scare the market into selling them. This practice hurts the company’s shareholders, causing their stock to trade below where it otherwise would trade. The short seller can then profit on the fear or doubt and book a profitable short sale.

How much can you make shorting a stock?

Beside the additional costs, another downside of shorting a stock is that you have less potential gain than going long the stock. That’s due to simple mathematics.

For example, compare the potential gain on buying 100 shares of fictional ABC stock trading at $100 per share. If the stock rises to $200, you will have made $10,000 from your initial investment. If the shares continue higher, you’ll make an additional $10,000 for every $100 rise in the stock price.

The stock can continue rising over years if the company is well run. There’s literally no cap on the upside of a stock, and stocks have made millionaires out of many people over time.

In contrast, the potential gain for a short is limited to the initial amount shorted. For example, if you short 100 shares of ABC at $100 per share, the most you could gain is $10,000 in total, and that’s only if the company goes to zero, or is basically bankrupted or completely fraudulent.

So the most you could profit in a short position is the initial value of the stock you shorted. And you have all those smaller costs chipping away at your gains as long as you maintain the short.

Plus, short sellers face a stock market that has a long-term upward bias, even if many of its companies do fail.

“The deck is actually stacked against the short seller, as stock prices do typically rise,” says Johnson, pointing to the S&P 500 index’s long-term record of rising about 10 percent annually since the 1920s. “Someone who consistently short sells the market is consistently a loser.”

So there’s a clear asymmetry between the potential profits of going long and going short. To succeed over time, you’ll have to identify and repeatedly pick the losing stocks.

The risks of short selling

The potential gain for long investors showcases the main risk for short sellers: the stock can continue rising indefinitely. When you sell a stock short, you have theoretically unlimited losses. That’s because the stock can continue rising and rising over time, wiping out other gains.

For example, imagine being a short seller in Amazon or Apple over the last decade, as those stocks soared. A buyer’s long-term gains become your long-term losses. That said, short sellers may jump in for short periods of time when a stock looks overvalued and profit on a decline.

In a worst-case scenario, the stock may experience a short squeeze, which could be ruinous to a short seller. A short squeeze occurs when the stock rises rapidly, forcing short sellers to close their position. Short sellers may be rushing to avoid a soaring stock or they may be forced to buy back stock as their losses mount and the equity for a margin loan in their account dwindles.

If enough of the stock is sold short and the stock begins to rise, it can kick off a period of soaring stock prices – sometimes running hundreds of percent higher. As the short squeeze hurts more and more short sellers, they are forced to buy stock at any price, pushing the price still higher.

That was the situation with video game retailer GameStop in early 2021, as a massive short squeeze sent its stock spiraling upward forcing many traders to cover their short positions.

So uncapped losses are the major risk to short selling, but short sellers also must cover other costs as mentioned before: the cost of borrowing the stock, a margin loan and any dividends that accrue to owners of the stock.

Is short selling right for you?

Short selling requires a lot of work and knowledge to succeed, and it’s not really a good idea for individual investors, who must match their wits against some of the sharpest investing minds. Given the challenges, even many of the professionals find shorting to be a grueling effort.

“It is most certainly not an activity that is appropriate for most investors,” Johnson says. “Short selling is really the purview of professional investors and hedge funds.”

Still, if you’re set on betting against a stock, you may be able to use put options to limit the worst risk of shorting, namely, uncapped losses. One strategy (buying a put option) allows you to profit on the decline of a stock and limit how much you’ll lose on the position. Options present other risks, however, that investors need to be fully aware of before they start trading them.

And most investors would do better sticking to a long-only portfolio.

“The good news is that one can make investing very simple, yet get great results,” Johnson says. “The best thing for most investors is to invest in a low-fee, broadly diversified, stock market index fund.”

Bottom line

Short selling can be lucrative, but it can take nerves of steel to weather the rise of the stock market. Given the risks, short sellers have to be unusually careful and well informed, lest they stumble into a stock that’s about to bound higher for years. So short selling is usually best left to sophisticated investors who have tons of research, deep pockets and a higher risk tolerance.

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