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, arbitragers, hedge funds, 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. Traders may also sell other securities short, including options.
Understanding the 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—in other words, if they already own shares of the same or a related stock outright.
Shorting ABC Shares
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 the shares with the hope that you can later repurchase them at a lower price, return them to the broker, and pocket the difference.
You proceed to sell the 10 borrowed shares at $50 each, pocketing $500 in cash. In reality, you would pay a small commission, and, depending upon timing, might also have to pay dividends to the buyer of your shares, but these are omitted in the example for simplicity. So you now have $500 in cash and have an obligation, at some point in the future, to purchase and return the 10 shares of ABC stock. 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 company happens to go bankrupt, the stock will be delisted and you can buy it back for a few pennies per share, most likely, and pocket almost all of the earlier sales proceeds as profit.
A Real Life Example
The most famous (and catastrophic) example of losing money due to shorting a stock is the Northern Pacific Corner of 1901. Shares of a particular railroad went up from $170 to $1,000 in a single day, bankrupting some of the wealthiest men in the United States as they tried to buy shares back and return them to the lenders from whom they had borrowed the stock to do their short sales.
Beware of the Risks
When you short a stock, you expose yourself to a potentially large financial risk. In some cases, when investors and traders see that a stock has a large short interest, meaning a big percentage of its available shares have been shorted by speculators, they attempt to drive up the stock price. This can force the speculators with short positions to "cover," or buy back the shares before the price goes too high, and this exerts a certain amount of control over the stock price before a large amount of speculation causes huge losses.
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. The market for a given stock has to be there. If no one is selling the stock, or there are many buyers, including panic buyers, caused by other short sellers attempting to close out their positions as they lose more and more money, you may be in a position to incur serious losses. You could also wake up to an announcement that a company's getting acquired for a 40 percent premium over its current stock price including a special $10 per share dividend, for example, which means short sellers are instantly impacted and may have serious losses.
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.
You may or may not have the opportunity to buy or sell on the way up or down. Prices may instantaneously reset, with the bid or ask prices jumping higher very quickly. 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. Finally, shorting a stock is subject to its own set of rules. For example, there are limitations to shorting a penny stock, and before you can begin shorting a stock, the last trade must be an uptick or small price increase.
Jacara 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.