The Basics of Shorting Stock
A Beginner's Guide for How to Short Stocks
Shorting stock has long been a popular trading technique for speculators, gamblers, arbitrageurs, hedge fund managers, and individual investors willing to take on a potentially substantial risk of capital loss. Shorting stock, also known as short selling, involves the sale of stock that the seller does not own, or shares that the seller has taken on loan from a broker.
- Short stock transactions occur because sellers believe a stock's price is headed downward.
- Stock prices can be volatile, and If you want to sell stock short, do not assume you can always repurchase it whenever you want, at any price.
- Shorting a stock is subject to its own set of rules that are different from regular stock investing.
Motivation to Sell Short
Short sellers take on these transactions because they believe a stock's price is headed downward, and that if they sell the stock today, they'll be able to buy it back at a lower price at some point in the future. If they accomplish this, they'll make a profit consisting of the difference between their sell and buy prices. Some traders do short selling purely for speculation, while 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.
Suppose you believe the stock price of ABC is grossly overvalued, and the stock's going to crash sometime soon. You believe this so strongly that you decide to borrow 10 shares of ABC stock from your broker and sell them at $50 each, pocketing $500 in cash.
So you now have $500 in cash and an obligation to purchase and return the 10 shares of ABC stock at some point in the future. If the stock goes up above the $50 price, you'll lose money because 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 went to $250 per share, you'd have to spend $2,500 to buy back the 10 shares you owe the brokerage. You still keep the original $500, so your net loss would be $2,000. On the other hand, if the stock went to $10 per share, you could repurchase the 10 shares for $100 and profit $400.
In reality, you would pay a small commission, and depending upon timing, you might also have to pay dividends to the buyer of your shares, but these are omitted in the example for simplicity.
Beware of the Risks
When you short a stock, you expose yourself to a potentially large financial risk. One famous—and catastrophic—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, resulting in the bankruptcy of some of the wealthiest men in the United States as they tried to repurchase shares and return them to the lenders from whom they had borrowed them from.
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. Understand that stock prices can be volatile, and 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 be there. If no one is selling the stock, or there are many buyers caused by other short sellers attempting to close out their positions as they lose money, you may be in a position to incur serious losses.
Different Than Investing
Shorting a stock is subject to its own set of rules that are different from regular stock investing. This includes 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. The risk of losses on a short sale is infinite, in theory, because the 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 and 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.