The Basics of Shorting Stock

A Beginner's Guide to Understanding How Shorting Stock Works

How to Short Stock
Shorting stock is the process of borrowing stock you don't own, selling it, and pocketing the proceeds. Later, you have to buy back the stock and return it to the owner from whom you borrowed the shares. This means a person who shorts a stock makes money when the stock declines, rather than appreciates. hh5800 / E+ / Getty Images

Shorting stock has long been a popular trading technique for speculators, gamblers arbitragers, hedge funds, and, yes, even many individual investors who are willing to take on what can be a substantial risk of permanent capital impairment.

You've already learned the definition of shorting stock but now I want to walk you through a straightforward example of how a shorting stock on the margin might look in the real world.

I believe it will make it much easier for you to visualize how it works, what the dangers are, and why someone might be tempted to engage in it despite the very real potential for throwing them into bankruptcy if they aren't careful as it can expose the owner to theoretically unlimited losses.

A Hypothetical Example of How Shorting Stock Might Work

Imagine that I own 10 shares of company ABC at $50 per share held in a margin account at a brokerage firm. You believe the stock price of ABC is grossly overvalued and is going to crash sometime soon. You are so convinced of this, you decide you want to borrow those 10 shares and sell them with the hope that you can later repurchase them at a lower price, returning them to me, and pocketing the difference.

You approach my stockbroker. You tell the stockbroker you will borrow the shares from my account, replacing them someday along with any dividends I should have received.The broker says, "Alright, I'll let you borrow Joshua's shares", takes them out of my account without me knowing - it never shows up on my account statement and I never have any other notification that it has been done - and lets you borrow them.

You then run out and sell those 10 shares at $50 each, pocketing $500 in cash minus a small commission, which we'll ignore for the sake of simplicity at the moment. (Institutional investors actually get paid for lending out their securities, which is one of the reasons some major financial institutions enjoy the practice.

They lend their stocks in exchange for certain collateral and increase the income they would otherwise enjoy.)

As a side note: In this alternate universe, this isn't a good deal for me. If you don't repay the shares, my brokerage firm will have to reimburse me for it but they could go bankrupt in a market meltdown, causing me to rely on the SIPC program (to learn more about this, read What Happens If My Broker Goes Bankrupt?). If my account balance exceeds the SIPC limit, I could lose a lot of my money because the stock that was supposed to be parked in my account wasn't really there.

Not only that, even if everything works out fine, while you have borrowed my stock, any dividend replacements you pay me aren't entitled to the super-low dividend tax rates but, rather, are taxed as ordinary income, which can be almost double the tax rate. Of course, there is an easy way to stop this from happening and that is to open a cash account instead of a margin account. Stocks held in cash accounts cannot be lent out to short sellers nor are they subject to rehypothecation risk.

Now, you are sitting on $500 in cash and have an obligation, at some point in the future, to return my 10 shares of ABC.

If the stock goes up, you lose money because you are going to have to pay a higher price to repurchase the shares and return them to my 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 me. You still keep the original $500 so your total loss would be $2,000 minus commissions and any dividends you had to pay along the way. On the other hand, if the company goes bankrupt, the stock will be delisted and you can buy it back for next to nothing - a few pennies per share, most likely - pocketing almost all of the earlier sales proceeds as profit.

The Dangers of Shorting Stock Should Not Be Underestimated

When you short a stock, you are exposing yourself to a lot of potential financial pain. In some cases, when investors and traders see that a stock has a large short interest (a big percentage of its float has been shorted by speculators), they will attempt to drive up the price to force the shorts to "cover", or buy back the shares before it gets too out of hand.

It is important to remember a few things if you are thinking about shorting stock. First, never assume you will be able to repurchase a stock you have shorted whenever you want at a price that resembles ordinary experience. The liquidity has to be there.If there are no sellers in the market, or there are so many buyers (including panic buying, which is caused by other short sellers attempting to close out their position as they lose more and more money), you have a serious problem.

The most famous, and catastrophic, example of this is the Northern Pacific Corner of 1901.Shares of a particular railroad went from $170 to $1,000 in a single day, bankrupting some of the wealthiest men in the United States as they tried to get their hands on shares to buy them back and return them to the lenders from whom they had borrowed the stock.

Next, never assume that for a stock to go from price $A to price $C, it has to go through price $B. You may or may not have the opportunity to buy or sell on the way up or down, prices may instantaneously reset, the bid or ask jumping. It is something that is obvious to experienced investors but new investors take for granted.

Even in regular stock investments that do not involve shorting stock, there is this mistaken idea that a stop loss order can protect you under all circumstances, which simply isn't true. The major risk as it pertains to shorting stock is a corporate buyout or merger.

It isn't unusual to wake up to an announcement that a company is going to be acquired for 40% higher than its stock price including a special $10 per share dividend or something, which means the short seller is instantly harmed in a major way.

Finally, shorting stock is subject to its own set of rules. For example, you cannot short a  penny stock, and before you can begin shorting a stock, the last trade must be an uptick or zero-plus tick.

If You Insist Upon Shorting Stock, Consider Buying an Out-of-the-Money Call Option As Partial Insurance Against Catastrophe

If you are going to short stock, think about limiting your potential losses by purchasing an out-of-the-money call option. Sure, it will cost you money and potentially cut into any gains you would have made but it might be the difference between a painful, buy survivable, disaster and a catastrophe that destroys your family's finances for years.

Let's look at an example. Right now, on March 19th, 2016, any fundamental investor or quantitative analyst can tell you the shares of Netflix are disgustingly, offensively overvalued. They trade at price-to-earnings ratio of more than 361. While it is true that a high p/e ratio does not always mean a stock is overvalued, in this case, it does. Even Netflix's management has expressed astonishment that investors are so foolish to pay a price this detached from reality.

The stock price is $101.12 per share. Imagine if you wanted to short it. To keep it simple, we'll say you want to short 100 shares and we'll ignore the small commissions you would otherwise owe. You borrow the stock, sell the shares, and pocket $10,112. At the same time, you decide to buy 1 call option covering 100 shares with a $200 strike price dated September 16th, 2016. The contract costs you $0.28 per share, or $28 total, plus a small commission.

Now, you are sitting there with $10,084 in cash in your account ($10,112 proceeds from selling borrowed stock minus the $28 you paid for the out-of-the-money call contract) plus a -100 shares of Netflix showing on your account register. If Netflix declines, you want to buy it back for less than $10,084 with the difference, adjusted for the commissions along the way, amounting to your profit.

However, if something crazy happens - say Netflix suddenly jumps to $500 a share - you would have an offset. Yes, you'd need to buy back 100 shares at $500 each for $50,000.Yes, you would have lost almost $40,000 shorting the stock. However, your call option would be worth a fortune. You'd be able to exercise it, force someone to sell you 100 shares of Netflix for $200 per share (taking $20,000 out of your pocket) then use those shares to replace the borrowed shares you sold earlier.

Put another way, before commissions, you'd have turned what would have been an almost $40,000 loss in a loss of a little less than $10,000. That's a roughly $30,000 savings. True, you still lost money shorting stock but as far as insurance policies go, it was a cheap one.

Buying a Put Option Is Often a More Intelligent Way To Gamble Than Shorting Stock

In many situations, buying a put option, which gives you the right, but not the obligation, to sell stock at a predetermined price is the more intelligent way to gamble on a company's shares collapsing. That type of trade involves its own unique risks but it can be far more compelling than shorting stock under the right circumstances because you can limit your total losses whereas your losses are theoretically unlimited when you short stock.

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.