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 should only be used by experienced investors and traders.
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.
- 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 as stocks tend to lose value faster than they appreciate.
Example of a Short Sale
For example, if an investor thinks that Facebook (FB) is overvalued at $325 per share, and is going to decline in price, the investor could "borrow" 10 shares of FB from their broker, and then sell the shares for the current market price of $325. If the stock goes down to $250, the investor could buy the 10 shares back at this price, return the borrowed shares to their broker, and net a profit of $750 ($3,250 - $2,500). However, if Facebook's share price rises to $375, the investor would lose $500 ($3,250 - $3,750).
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 $325, the maximum they could lose is $325 because the stock cannot drop to less than $0. In other words, the maximum 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 FB (or short sold it), and the price rose to $500 before the investor exited, he or she 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, triggering 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. In January 2021, followers of a popular Reddit page called Wall Street Bets banded together to cause a massive short squeeze in stocks of struggling companies with very high short interest, such as video game retailer GameStop and movie theater chain AMC Entertainment, causing their share price to soar 17-fold and 6-fold in January alone.
Short selling can generally only be undertaken in a margin account, a type of account offered by brokerages where they lend funds to investors and traders for trading securities. The short seller therefore 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 in 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 that 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 be used for 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 simultaneously for both speculation and hedging. 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.
While short selling does present investors with an opportunity to make profits in a declining or neutral market, it should only be attempted by sophisticated investors and advanced traders due to its risk of infinite losses.
When Does Short Selling Make Sense?
Short selling is not a strategy used by many investors largely because the expectation is that stocks will rise in value over time. The stock market, in the long run, tends to go up although it is occasionally punctuated by bear markets where 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, short selling should only be attempted by advanced investors who have a high tolerance for risk and understand the risks associated with this strategy.
Costs Associated with Short Selling
Trading commissions are not the only expense involved when short selling. There are other costs involved in short selling, such as:
- Margin Interest - As 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 pro-rated 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 spin-offs.
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%, as 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, where 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 December 31, 2020, would be faced with a loss of $306.16 per share, or $30,616, if the short position was still open on January 29, 2021. As 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.