How to Short a Stock and Why It Can Be Dangerous

How to Short a Stock and Why It Can Be Dangerous

Depending on your level on investing expertise, you might have come across the term “selling short.” It’s another way that investors can make money even in a down market. To make money with this tactic, you first need to know how to short a stock.

Short selling isn’t something you should do if you are new to investing. While many people have made small fortunes by shorting a stock, countless others have lost large sums of money.

Before you decide to short a stock, consider a few of these tips to help determine if it is the best way to increase the value of your investment portfolio.


What Does Short Selling Mean?

A common catchphrase you will hear in any Investing 101 class is “Buy Low, Sell High.”

With most stock trades, we buy stocks with the expectation that they will appreciate and sell them for a profit once the share price increases plus any dividend payouts.

Short selling takes the opposite approach.

You “Sell High, Buy Low” because you anticipate a stock or future will significantly drop in value in the near future and you plan to buy it at a lower price.

The difference between the original short sell price ($50) and the lower buy price ($40) is your profit. If you buy back the shares at a higher price ($60), you lose money.

As you don’t physically own the stock being shorted, the brokerage must sell shares in their reserves or find a third-party owner willing to lend their shares. If nobody is willing to lend shares, you cannot short the stock.

Until you buy the stock back, you will be charged margin interest. These fees are the reason you should only consider short selling for the immediate future.


Pros of Short Selling

Make Money in Any Market

Investors from all walks of life, from individual investors to hedge fund managers, have been successful at short selling. Even in bull markets, some stocks lose value. It might be harder in bull markets to short stocks, but, there’s always a way to make money from market losers.

Even in bear markets, you can also make money shorting stocks as you “bet” which stocks will continue to drop in value. You will just want to make sure that choose stocks with lots of trading activity and low margin interest to increase your chances of earning a profit.

Make Money When Others Lose Money

The majority of investors buy stocks that will appreciate in value. They will sell them when they feel they are overvalued and going to start losing value. This can be a perfect opportunity to short a stock as your profit potential increases when the share price decreases.

You might decide to short a stock ahead of an earnings report when you feel they will miss analyst projections. Or you might decide to short a stock ahead of a bubble like the 2000 “dot com bubble” or the “commodity bubble” preceding the 2008 Great Recession.

Timing your short means you can capture a profit when share prices decrease because you were one step ahead of the market.

Investment Diversification

Short selling is also a good way to increase your portfolio size when you don’t like your investment choices for conventional buying to go long as the market might be flat or overvalued. It can be a good way to make money if you are willing to trade on margin for a few days, weeks, or months.

And, it’s a great way to “hedge” against market corrections that affect your long-term investments.


How to Short a Stock

How do you short a stock? Firstly, you need to request approval from your brokerage account to start margin trading (i.e. short selling). While short selling is a fairly simple process, it is riskier than regular stock trading and you are charged interest. Short selling can get expensive quickly due to margin interest.

Once approved, your brokerage might have borrowing limits that are half the amount you want to short.

For example, if you have $1,000 in a margin account, you can short up to $2,000. To short larger amounts, you need to contribute more money to a margin account.

We will now do a little exercise to short a stock.

Remember, we are looking for stocks that are going to lose value in the short-term and will depreciate quick enough to offset the trade commission and margin interest charges. If they don’t, your chances of losing money increases.

Step 1: Choose a Stock to Short

For this exercise, we are going to short sell Company Z.

It is currently trading for $50 a share. We are reasonably certain that the share price is going to drop in the near future because of recent missed earnings reports and they have been curtailing operations.

In short, we are shorting Company Z because the current share price doesn’t accurately reflect the true value of the company.


Step 2: Initiate a Short Sell

On your brokerage platform, enter the necessary data to short Company Z. This includes the number of shares and the per share bid price.

For this exercise, we will stick with the selling price of $50 a share and we want to sell 200 shares.

Before commissions and fees, short selling 200 shares for $50 (200 x 50) is $10,000.

The share price needs to go below $50 for us to earn a profit.


Step 3: Confirm and Execute the Trade

When you click the confirm button to submit the order, your brokerage will immediately begin working to execute your order at that bid price.

If they own shares of Company Z, your brokerage might borrow the shares. Otherwise, they will acquire the sold shares from another party.

After three days, the trade will be settled and you have officially shorted 200 shares of Company Z. At this point, your brokerage might require you to keep a percentage of the current market value in your margin account, such as 30%.

Sticking with our example of shorting 200 shares of Company Z at $50 per share with a market value of $10,000, your margin account will need at least $3,000 of cash.

If the market value increase to $11,000, you will need to keep at least $3,300 in your margin account. But, if the value decreases to $9,000 you only need to keep $2,700 in it.


Step 4: Buy When the Price Drops

When the share price drops, you earn a profit. If you buy back the 200 shares at $40 apiece, which is $10 less than what you shorted them for, you will have a total profit of $2,000.

Trade fees and interest will be withheld from the selling price and the remaining money is your profit. The sooner you buy, the less interest you pay.


Example for Earning a Profit​

  • Original Market Value at Time of Short Sell: $10,000 (200 shares at $50)
  • Market Value When Buy Shares at $40 each: $8,000 (200 shares at $40)
  • Total Profit: $2,000

You don’t have to buy the shares as soon as the share price drops, just like you don’t have to sell a regular investment as soon as the price increases. But you cumulative margin interest increases each day you continue to hold the shorted stocks which can potentially offset any additional gains.

The more the share price drops, the more you earn. For example, if you wait to buy back the Company Z shares at $30, you will profit $4,000. If you can afford to wait that long, your profit only increases as the share price continues to drop.


What If The Share Price Remains the
Same or Rises?

In addition to profiting from selling short, you can also “break even” or lose money.

You will lose money if Company Z’s share price increase. If you buy the shares at $60, you will lose $2,000, and you still have to pay the accrued margin interest.

Example for Losing Money​

  • Original Market Value at Time of Short Sell: $10,000 (200 shares at $50)
  • Market Value When Buy Shares at $60 each: $12,000 (200 shares at $60)
  • Total LOSS: $2,000

If you buy back Company Z at the original short price ($50), you will earn $0 but still owe margin interest. After factoring in the trade fees and interest, you still lose money.

Example for Breaking Even​

  • Original Market Value at Time of Short Sell: $10,000 (200 shares at $50)
  • Market Value When Buy Shares at $50 each: $10,000 (200 shares at $50)
  • Total Profit: $0

Why is Selling Short Dangerous?

Why is Selling Short Dangerous

Shorting a stock is dangerous because you only profit when the share price drops enough to offset the trade fees and marginal interest. If you buy for the same price that you shorted it for or a higher price, you lose money once you factor in interest and trade commissions.

You Don’t Collect Stock Dividends

If the stock you short pays a dividend, you don’t get to collect the dividend. It goes to the actual owner of the stock, whether that is your brokerage or a third-party.

In fact, you might even be responsible for paying the dividend which increases your costs even more. Depending on how long you plan to short a stock, you might decide to only trade stocks that don’t pay dividends.

Interest Accrues Daily

Time isn’t necessarily your friend. When you short a stock, interest accrues daily. If a stock doesn’t drop in value quickly enough, you might have to buy the shares just to avoid losing more money than you can afford.

The interest can also be a hidden fee because the brokerage will collect their interest before you collect your money.

Interest Rates Fluctuate

Just as share prices fluctuate, margin interest rates fluctuate too on a daily basis. Rates are contingent on the trading volume and share price.

Shorting stocks that are actively owned and traded can help reduce the interest volatility as shares are constantly changing hands.

The Share Price Might Not Drop

Nobody can accurately predict the movement of a single share from one moment to the next. When you short a stock, you need to be prepared for the stock to not drop in price as quickly as you anticipate. It may hover around the original short price or even climb in value.

At some point, you have to determine how high you are willing to see the stock climb or how much interest you are willing to pay before buying back the shares to cover your losses.

Losses Are Infinite

When buying a stock, you know you will only “lose everything” when the share price reaches $0. When you short a stock, you lose money each time the price rises.

As there is no price ceiling for stocks, you can easily lose your initial investment and even more.

The Lender Might Force a “Buy-In” or “Short Squeeze”

If you short a stock with a limited number of shares or if the share price climbs significantly, the lender might require you to buy back the stock before you are ready. This is because they need to sell it to realize a profit and since they lent it to you, you are the primary buyer.

When a buy-in happens, you are required to purchase the shares at the current price and accept the loss.

Regulatory Limits

Another forced buyback scenario is regulatory actions. The government might place a ban on shorting certain sectors or the broad market to prevent investing panic.

If this happens, share prices typically increase sharply and you need to buy the shares at a loss.

Riskier Than Options Trading

If short selling is too risky for you, then you can also consider purchasing a put option. With this method, you can still profit when a stock depreciates. The one primary difference is that the option will expire after a predetermined period whether it’s one month or one year.

Put options are also less risky because they don’t accrue margin interest. This means you aren’t subject to mandatory buy-ins or squeezes.

Even better, put options don’t accrue interest. Short selling can be more effective if you don’t have a trading timeframe in mind, but, that flexibility comes at a price.


Conclusion

Short selling is a time-tested way to make money from assets that depreciate. The challenge is knowing when that asset will drop and how low it will go. If it drops quicker than the interest accrues, you can earn a tidy sum of money when you buy the shorted shares.

Otherwise, the potential upside might not be worth the risk. This is why inexperienced investors might get caught off-guard by short selling.

Andrew
 

My name is Andrew and I run Slick Bucks to help folks learn to manage money cleverly, and how that clever management can make you wealthier.

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