What Is Short Selling?

Short selling is an investment or trading strategy that speculates on the decline in a stock or other securities price. It is an advanced strategy that should only be undertaken by experienced traders and investors.

Traders may use short selling as speculation, and investors or portfolio managers may use them as a hedge against the downside risk of a long position in the same security or a related one. Speculation carries the possibility of substantial risk and is an advanced trading method. Hedging is a more common transaction involving placing an offsetting position to reduce risk exposure.

In short selling, a position is opened by borrowing shares of a stock or other asset that the investor believes will decrease in value by a set future date—the expiration date. The investor then sells these borrowed shares to buyers willing to pay the market price. Before the borrowed shares must be returned, the trader is betting that the price will continue to decline and they can purchase them at a lower cost.

The risk of loss on a short sale is theoretically unlimited since the price of any asset can climb to infinity. Also, short selling stocks require a margin account and usually incurs interest charges based on the value of the stock that is held short.

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Short Selling

How Short Selling Works

Wimpy of the famous Popeye comic strip would have been a perfect short seller. The comic character was famous for saying he would "gladly pay next Tuesday for a hamburger today." In short selling, the seller opens a position by borrowing shares, usually from a broker-dealer. They will try to profit on the use of those shares before they must return them to the lender.

To open a short position, a trader must have a margin account and will usually have to pay interest on the value of the borrowed shares while the position is open. Also, the Financial Industry Regulatory Authority, Inc. (FINRA) the New York Stock Exchange (NYSE), and the Federal Reserve have set minimum values for the amount that the margin account must maintain—known as the maintenance margin.

To close a short position, a trader buys the shares back on the market—hopefully at a price less than what they borrowed the asset—and returns them to the lender or broker. Traders must account for any interest charged by the broker or commissions charged on trades.

The process of locating shares that can be borrowed and returning them at the end of the trade are handled behind the scenes by the broker. Opening and closing the trade can be made through the regular trading platforms with most brokers. However, each broker will have qualifications the trading account must meet before they allow margin trading.

Key Takeaways

  • Short selling occurs when an investor borrows a security and sells it on the open market, planning to buy it back later for less money.
  • Short sellers bet on, and profit from, a drop in a security's price.
  • Short selling has a high risk/reward ratio: It can offer big profits, but losses can mount quickly and infinitely.

Short Selling for a Profit

Imagine a trader who believes that XYZ stock—currently trading at $50—will decline in price in the next three months. They borrow 100 shares and sell them to another investor. The trader is now “short” 100 shares since they sold something that they did not own but had borrowed. The short sale was only made possible by borrowing the shares, which may not always be available if the stock is already heavily shorted by other traders.

A week later, the company whose shares were shorted reports dismal financial results for the quarter, and the stock falls to $40. The trader decides to close the short position and buys 100 shares for $40 on the open market to replace the borrowed shares. The trader’s profit on the short sale, excluding commissions and interest on the margin account, is $1,000: ($50 - $40 = $10 x 100 shares = $1000).

Short Selling for a Loss

Using the scenario above, let's now suppose the trader did not close out the short position at $40 but decided to leave it open to capitalize on a further price decline. However, a competitor swoops in to acquire the company with a takeover offer of $65 per share and the stock soars. If the trader decides to close the short position at $65, the loss on the short sale would be $1,500: ($50 - $65 = negative $15 x 100 shares = $1500 loss). Here, the trader had to buy back the shares at a significantly higher price to cover their position.

Pluses and Minuses of Short Selling

As the second scenario shows, selling short can be costly if the seller guesses wrong about the price movement. A trader who has bought stock can only lose 100% of their outlay if the stock moves to zero.

However, a trader who has shorted stock can lose much more than 100% of their original investment. The risk comes because there is no ceiling for a stock’s price, it can rise to infinity and beyond—to coin a phrase from another comic character, Buzz Lightyear. Also, while the stocks were held the trader had to fund the margin account. Even if all goes well, traders have to figure in the cost of the margin interest when calculating their profits.

Pros

  • High profits

  • Little initial capital required

  • Leveraged investments possible

  • Hedge against other holdings

Cons

  • Potentially unlimited losses

  • Margin account necessary

  • Margin interest incurred

  • Short squeezes

When it comes time to close a position, a short seller might have trouble finding enough shares to buy—if a lot of other traders are also shorting the stock or if the stock is thinly traded. Conversely, sellers can get caught in a short squeeze loop if the market, or a particular stock, starts to skyrocket.

On the other hand, strategies which offer high risk also offer a high-yield reward. Short selling is no exception. If the seller predicts the price moves correctly, they can make a tidy return on investment (ROI), primarily if they use margin to initiate the trade. Using margin provides leverage, which means the trader did not need to put up much of their capital as an initial investment. If done carefully, short selling can be an inexpensive way to hedge, providing a counterbalance to other portfolio holdings.

Short Selling Metrics

Two metrics used to track short selling activity on a stock are:

  1. Short interest ratio (SIR)—also known as the short float—measures the ratio of shares that are currently shorted compared to the number of shares available or “floating” in the market. A very high SIR is associated with stocks that are falling or stocks that appear to be overvalued.
  2. The short interest to volume ratio—also known as the days to cover ratio—the total shares held short divided by the average daily trading volume of the stock. A high value for the days to cover ratio is also a bearish indication for a stock.

Both short-selling metrics help investors understand whether the overall sentiment is bullish or bearish for a stock.

For example, after oil prices declined in 2014, General Electric Co.’s (GE) energy divisions began to drag on the performance of the entire company. The short interest ratio jumped from less than 1% to more than 3.5% in late 2015 as short sellers began anticipating a decline in the stock. By the middle of 2016, GE’s share price had topped out at $33 per share and began to decline. By February 2019, GE had fallen to $10 per share, which would have resulted in a profit of $23 per share to any short sellers lucky enough to short the stock near the top in July 2016.

The Short Squeeze

If a stock is actively shorted with a high short float and days to cover ratio, it is also at risk of experiencing a short squeeze. A short squeeze happens when a stock begins to rise and short sellers cover their trades by buying their short positions back. This buying can turn into a feedback loop. Demand for the shares attracts more buyers, which pushes the stock higher, causing even more short-sellers to buy back or cover their positions.

Short Selling's Reputation

Sometimes short selling is criticized, and short sellers are viewed as ruthless operators out to destroy companies. However, the reality is that short selling provides liquidity to markets and can help prevent bad stocks from rising on hype and over optimism. Evidence of this benefit can be seen in asset bubbles that disrupt the market. Assets that lead to bubbles—like the mortgage-backed security market before the 2008 financial crisis—are frequently difficult, or impossible, to short.

Short selling activity is a legitimate source of information about market sentiment and demand for a stock. Without this information, investors may be caught off-guard by negative fundamental trends or surprising news.

Unfortunately, short selling gets a bad name due to the practices employed by unethical speculators. These unscrupulous types have used short selling strategies and derivatives to artificially deflate prices and conduct “bear raids” on vulnerable stocks. Most forms of market manipulation like this are illegal in the U.S., but it still happens periodically.

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Real World Example of Short Selling

Unexpected news events can initiate a short squeeze which may force short sellers to buy at any price to cover their margin requirements. For example, in October 2008, Volkswagen briefly became the most valuable publicly traded company in the world during an epic short squeeze.

In 2008, investors knew that Porsche was trying to build a position in Volkswagen and gain majority control. Short sellers expected that once Porsche had achieved control over the company, the stock would likely fall in value, so they heavily shorted the stock. However, in a surprise announcement Porsche revealed that they had secretly acquired more than 70% of the company using derivatives, which triggered a massive feedback loop of short sellers buying shares to close their position.

Short sellers were at a disadvantage because 20% of Volkswagen was owned by a government entity that wasn’t interested in selling, and Porsche controlled another 70%, so there were very few shares available on the market—float—to buy back. Essentially both the short interest and days to cover ratio had exploded higher overnight, which caused the stock to jump from the low €200s to over €1,000.

A characteristic of a short squeeze is that they tend to fade quickly, and within several months Volkswagen’s stock had declined back into its normal range.