Shorting stock is a popular trading technique for investors with a lot of experience, including hedge fund managers. It can create large profits. But it also involves the potential to lose a lot of money.
Shorting stock, also known as "short selling," involves the sale of stock that the seller does not own or has taken on loan from a broker. Investors who short stock must be willing to take on the risk that their gamble might not work.
- Short stock trades occur because sellers believe a stock's price is headed downward.
- Shorting stock involves selling batches of stock to make a profit, then buying it back cheaply when the price goes down.
- Stock prices can be volatile, and you cannot always repurchase shares at a lower price whenever you want.
- Shorting a stock is subject to its own set of rules that are different from regular stock investing.
Why Sell Short?
Usually, you would short stock because you believe a stock's price is headed downward. The idea is that if you sell the stock today, you'll be able to buy it back at a lower price in the near future.
If this strategy works, you can make a profit by pocketing the difference between the price when you sell and the price when you buy. You will still end up with the same amount of stock of the same stock that you had originally.
Some traders do short selling purely for speculation. Others want to hedge, or protect, their downside risk if they have a long position.
A long position may be owning shares of the same or a related stock outright.
How Shorting Stock Works
Usually, when you short stock, you are trading shares that you do not own.
For example, if you think the price of a stock is overvalued, you may decide to borrow 10 shares of ABC stock from your broker. If you sell them at $50 each, you can pocket $500 in cash.
At that point, you have $500 in cash, but you also need to buy and return the 10 shares of stock to your broker soon. If the price of the stock goes down to $25 per share, you can buy the 10 shares again for only $250.
Your total profit would be $250: the $500 profit you made at first, minus the $250 you spend to buy the shares back. But if the stock goes up above the $50 price, you'll lose money. You'll have to pay a higher price to repurchase the shares and return them to the broker's account.
For example, if the stock were to go to $250 per share, you'd have to spend $2,500 to buy back the 10 shares you'd owe the brokerage. You'd still keep the original $500, so your net loss would be $2,000.
Calculating profit for a short sale is slightly more complex. You would pay a small commission for the trade, which would come out of your profit. Depending upon timing, you might also have to pay dividends to the buyer of your shares.
What Are the Risks of Short Selling?
When you short a stock, you expose yourself to a large financial risk.
One famous example of losing money due to shorting a stock is the Northern Pacific Corner of 1901. Shares of the Northern Pacific Railroad shot up to $1,000. Some of the wealthiest men in the United States went bankrupt as they tried to repurchase shares and return them to the lenders from whom they had borrowed them.
If you want to sell stock short, do not assume you'll always be able to repurchase it whenever you want, at a price you want. Stock prices can be volatile.
When investing, you should never assume that for a stock to go from price A to price C, it has to go through price B. The market for a given stock has to exist. You may end up losing significant money if:
- No one is selling the stock.
- There are too many buyers because other short sellers are trying to close out their positions as well.
How Is Short Selling Different From Regular Investing?
Shorting a stock has its own set of rules, which are different from regular stock investing, including a rule designed to restrict short selling from further driving down the price of a stock that has dropped more than 10% in one day, compared to the previous day's closing price.
In theory, the risk of losses on a short sale is infinite. A stock price could continue to rise with no limit. The short-selling tactic is best used by seasoned traders who know and understand the risks.
The Balance does not provide tax, investment, or financial services or advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.