How an Investor Can Make Money Short Selling Stocks

How Can Short Selling Make Money?

One way to make money on stocks for which the price is falling is called short selling (also known as "going short" or "shorting"). Short selling sounds like a fairly simple concept in theory—an investor borrows a stock, sells the stock, and then buys the stock back to return it to the lender. In practical terms, however, it is an advanced strategy that only experienced investors and traders should use.

Short sellers are wagering that the stock they are short selling will drop in price. If the stock does drop after selling, the short seller buys it back at a lower price and returns it to the lender. The difference between the sell price and the buy price is the short seller's profit.

Key Takeaways

  • Short sellers are wagering that a stock will drop in price.
  • Short selling is riskier than going long on a stock because, theoretically, there is no limit to the amount you could lose.
  • Speculators short sell to capitalize on a decline, while hedgers go short to protect gains or minimize losses.
  • When successful, short selling can net the investor a decent profit in the short term because stocks tend to lose value faster than they appreciate.
  • Inexperienced investors may find that short selling stocks is not to their advantage.

Example of a Short Sale

For example, suppose an investor thinks that Meta Platforms Inc. (META), formerly Facebook, is overvalued at $200 per share and will decline in price. In that case, the investor could "borrow" 10 shares of Meta from their broker and then sell the shares for the current market price of $200. If the stock goes down to $125, the investor could buy the 10 shares back at this price, return the borrowed shares to their broker, and net $750 ($2,000 - $1,250). However, if Meta's share price rises to $250, the investor would lose $500 ($2,000 - $2,500).

What Are the Risks?

Short selling substantially amplifies risk. When an investor buys a stock (or goes long), they stand to lose only the money that they have invested. Thus, if the investor bought one FB share at $200, the maximum they could lose is $200 because the stock cannot drop to less than $0. In other words, the lowest value that any stock can fall to is $0.

However, when investors short sell, they can theoretically lose an infinite amount of money because a stock's price can keep rising forever. As in the example above, if an investor had a short position in Meta (or short sold it), and the price rose to $375 before the investor exited, they would lose $175 per share.

Another risk faced by short sellers is that of a "short squeeze," in which a stock with a large short interest (i.e., a stock that has been heavily sold short) climbs rapidly in price. This triggers a steeper price ascent in the stock as more and more short sellers buy back the stock to close out their short positions and cap their losses.

Short Squeeze

In January 2021, followers of a popular Reddit page called WallStreetBets banded together to cause a massive short squeeze in stocks of struggling companies with very high short interest, such as video game retailer GameStop Corp. (GME). This caused the company's share prices to soar 17-fold in January alone.

Short selling can generally only be undertaken in a margin account, a type of account by which brokerages lend funds to investors and traders for trading securities. Therefore, the short seller has to monitor the margin account closely to ensure that the account always has sufficient capital or margin to maintain the short position.

If the stock that the trader has sold short suddenly spikes in price (for example, if the company announces in its quarterly report that earnings have exceeded expectations), the trader will have to pump additional funds into the margin account right away, or else the brokerage may forcibly close out the short position and saddle the trader with the loss.

If an investor shorts a stock, there is technically no limit to the amount they could lose because the stock can continue to go up in value indefinitely. In some cases, investors could even end up owing their brokerage money.

Why Do Investors Go Short?

Short selling can serve the purposes of speculation or hedging. Speculators use short selling to capitalize on a potential decline in a specific security or across the market as a whole. Hedgers use the strategy to protect gains or mitigate losses in a security or portfolio.

Notably, institutional investors and savvy individuals frequently engage in short-selling strategies for both speculation and hedging simultaneously. Hedge funds are among the most active short sellers and often use short positions in select stocks or sectors to hedge their long positions in other stocks.

Though short selling does present investors with an opportunity to make profits in a declining or neutral market, only sophisticated investors and advanced traders should attempt it due to its risk of infinite losses.

When Does Short Selling Make Sense?

Short selling is not a strategy many investors use, largely because the expectation is that stocks will rise in value over time. In the long run, the stock market tends to go up, although it is occasionally punctuated by bear markets in which stocks tumble significantly.

For the typical investor with a long-term investment horizon, buying stocks is a less risky proposition than short selling. Short selling may only make sense in certain situations, such as in a protracted bear market or if a company is experiencing financial difficulties. That said, only advanced investors who have a high tolerance for risk and understand the risks associated with short selling should attempt it.

Less Risky Alternative to Short Selling

An alternative to short selling that limits your downside exposure is to buy a put option on the same stock. Holding a put option gives the investor the right, but not the obligation, to sell the underlying stock at a stated price, called the strike price. If the price of the stock in question rises rather than falls, the investor's loss is limited to the amount paid for the put option, called the option premium, plus any commissions.

The option premium will vary based on the strike price and the expiration date of the put option. The higher the strike price is and the longer into the future the expiration date is, the higher the option premium will be.

Using shares of Meta again as an example, it was trading at about $200 on Mar. 4, 2022. At that time, a put option with a strike price of $200 expiring on Mar. 18, 2022, cost about $13 per share in terms of option premium, plus commissions. Thus, if the price of Meta actually rose above $200, the investor's loss would be limited to $13 per share plus commissions.

Costs Associated With Short Selling

Trading commissions are not the only expense involved when short selling. There are other costs, such as:

  • Margin Interest: Because short selling can generally only be undertaken in a margin account, the short seller has to pay interest on the borrowed funds.
  • Stock borrowing costs: Shares of some companies may be difficult to borrow because of high short interest or limited share float. In order to borrow these shares for short selling, the trader must pay a "hard-to-borrow" fee that is based on an annualized rate, which can be quite high and is prorated for the number of trades that the short trade is open.
  • Dividends and other payments: The short seller is also on the hook to make dividend payments on the shorted stock, as well as payments for other corporate events associated with the shorted stock, such as stock splits and spinoffs.

What Is the Maximum Profit You Can Make From Short Selling a Stock?

The maximum profit you can theoretically make from short selling a stock is 100% because the lowest price at which a stock can trade is $0. The actual profit on a successful short trade is likely to be below 100% after factoring in expenses associated with the short position, such as stock borrowing costs and margin interest.

Can You Really Lose More Than You Have Invested in a Short Sale?

Yes, you can lose much more than you have invested in a short sale; in theory, your losses can be infinite. This is the reverse of a conventional "long" strategy, by which the maximum gain on a stock you have purchased is theoretically infinite, but the most you can lose is the amount invested. As an example of the devastating losses that can be inflicted on a short sale by runaway price appreciation, consider this situation. An investor who had a short position of 100 shares in GameStop as of Dec. 31, 2020, would be faced with a loss of $306.16 per share, or $30,616, if the short position was still open on Jan. 29, 2021. Because the stock soared from $18.84 to $325.00 over this one-month period, the investor's return would be -1,625%.

Is Short Selling Bad for the Economy?

Short selling has acquired a negative connotation because some unscrupulous short sellers have used unethical tactics to drive down stock prices. But when used in the correct manner, short selling facilitates the smooth functioning of financial markets by providing market liquidity, acting as a reality check for investors' unrealistic expectations and thus reducing the risk of market bubbles and enabling downside risk mitigation.

Article Sources
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  1. Yahoo Finance. "GameStop Corp. (GME)."

  2. Yahoo Finance. "Meta Platforms, Inc. (FB)."

  3. Nasdaq. "FB Option Chain."

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