How To Make Money Shorting Stocks – Short selling is an investment or trading strategy that speculates on a decline in the price of a stock or other security. It is an advanced strategy that only experienced traders and investors should undertake.
Traders can use short sales as speculation, and investors or portfolio managers can use them as a hedge against the downside risk of a long position in the same or related security. Speculation involves the possibility of significant risk and is an advanced method of trading. Hedging is a more common transaction that involves taking a hedging position to reduce risk exposure.
How To Make Money Shorting Stocks
In short selling, a position is opened by borrowing shares of a stock or other asset that the investor believes will decline in value. 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 fall and that he can buy the shares at a lower cost. The risk of loss in a short sale is theoretically unlimited, as the price of any asset can rise to infinity.
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With short selling, a seller opens a short position by borrowing shares, usually from a broker-dealer, hoping to buy them back for a profit if the price falls. Shares must be borrowed because you cannot sell shares that do not exist. To close out a short position, a trader buys the shares back into the market—hopefully at a price lower than what the asset was borrowed at—and returns them to the lender or broker. Traders must account for any interest charged by the broker or commissions charged on trades.
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 (FINRA), which enforces the rules and regulations governing registered broker-dealers and broker-dealer firms in the United States, the New York Stock Exchange (NYSE) and the Federal Reserve have set minimum prices for the amount the margin account must be maintained—known as maintenance margin. If an investor’s account value falls below the maintenance margin, more funds are required or the position may be sold by the broker.
The process of identifying stocks that can be borrowed and returning them at the end of the trade is done behind the scenes by the broker. Opening and closing the trade can be done through regular trading platforms with most brokers. However, each broker will have qualifications that the trading account must meet before allowing margin trading.
The most common reasons for participating in short selling are speculation and hedging. A speculator makes a pure price bet that it will fall in the future. If they are wrong, they will have to buy the shares back higher, at a loss. Because of the additional risks in short selling due to the use of margin, it is usually conducted over a shorter time horizon and is therefore more likely to be an activity conducted for speculation.
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People can also sell short to hedge a long position. For example, if you have call options (which are long positions), you may want to sell short against that position to secure profits. Or, if you want to limit losses to the downside without actually exiting a long stock position, you can sell short a stock that is closely related to it or highly correlated with it.
Imagine a trader who believes that XYZ stock—currently trading at $50—will decline in price over the next three months. They borrow 100 shares and sell them to another investor. The trader is now “short” 100 shares after selling something he didn’t own but borrowed. The short sale was made possible only 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, excluding commissions and interest in the margin account, is $1,000 ($50 – $40 = $10 × 100 shares = $1,000).
Using the above scenario, let’s now assume that the trader did not close the short position at $40, but decided to leave it open to capitalize on a further decline in price. However, a competitor swoops in to acquire the company with a takeover bid of $65 per share, and the stock soars.
What Does Shorting A Stock Mean?
If the trader decides to close the short position at $65, the short sale loss will be $1,500 ($50 – $65 = negative $15 × 100 shares = $1,500 loss). Here, the trader had to buy back the shares at a significantly higher price to cover his position.
Apart from speculation, short selling has another useful purpose – hedging – which is often perceived as the lower risk and more respectable avatar of shorting. The primary objective of hedging is protection, as opposed to the pure profit motive of speculation. Hedging is done to protect gains or mitigate losses in a portfolio, but since it has significant costs, the vast majority of retail investors do not consider it during normal periods.
The cost of hedging is twofold. There are the actual costs of hedge placement, such as costs associated with short selling or premiums paid on protective rights contracts. Also, there is the opportunity cost of capping the portfolio if markets continue to move higher. As a simple example, if 50% of a portfolio is hedged closely to the Standard & Poor’s 500 Index (S&P 500) and the index moves up 15% over the next 12 months, the portfolio will only capture about half of that gain , or 7.5%.
Selling short can be costly if the seller guesses wrong about the price movement. A trader who has bought stocks can only lose 100% of his outlay if the stock moves to zero.
How To Make Money Selling Stocks Short
However, a trader who has shorted stocks can lose much more than 100% of their initial investment. The risk comes because there is no upper limit to a stock’s price—it can rise “to infinity and beyond,” to coin a phrase from the comic character Buzz Lightyear. Also, as long as stocks were held, the trader had to fund the margin account. Even if all goes well, traders must factor in the cost of margin interest when calculating their profits.
When it comes time to close out a position, a short seller may struggle to find enough shares to buy—if many other traders are also shorting the stock, or if the stock is trading thinly. Conversely, sellers can get caught in a short squeeze loop if the market or a particular stock begins to soar.
On the other hand, strategies that offer high risk also offer a high return reward. Short sales are no exception. If the seller correctly anticipates price movements, he can make a tidy ROI, especially if he uses margin to initiate the trade. Using margin provides leverage, meaning the trader did not have 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 hedge against other portfolio holdings.
Novice investors should generally avoid short selling until they have more trading experience. That said, short selling through exchange-traded funds (ETFs) is a somewhat safer strategy due to the lower risk of short-term capital squeeze.
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In addition to the aforementioned risk of losing money on a trade from a stock’s price going up, short selling has additional risks that investors should consider.
Shorting is known as margin trading. When you short sell, you open a margin account, which allows you to borrow money from the brokerage using your investment as collateral. Just like when you are very much on the margin, it is easy to get away with losses because you have to meet the minimum maintenance requirement of 25%. If your account falls below this, you will be subject to a margin call and forced to put in more cash or liquidate your position.
Even if a company is overvalued, it could take some time for its stock price to decline. Meanwhile, you are vulnerable to interests, call margins and calls.
If a stock is actively shorted with a high short ratio and days to cover (more on that below), it is also at risk of experiencing a short squeeze. A short squeeze occurs when a stock starts to rise and short sellers cover their trades by buying back their short positions. This purchase can become a feedback loop. Demand for the stock attracts more buyers, which pushes the stock higher, forcing even more short sellers to buy back or cover their positions.
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Regulators may sometimes impose bans on short selling in a specific sector, or even the broad market, to prevent panic
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