You think a stock will go up, so you buy it. You’re long the stock. Pretty straightforward.
If you think a stock will go down, you have options, but they’re relatively complicated. Among them is learning how to short a stock. But before you do this, you should learn the ins and outs, risks and alternatives to short-selling.
Understanding short-selling stocks
Buy low, sell high. It’s the ultimate goal of stock traders and investors everywhere. Buying stocks is generally a simple process with clearly defined risk and reward.
It’s not quite as simple to short a stock. To get short, you do pretty much the opposite. To short-sell a stock, you borrow shares from your brokerage firm, sell them on the open market and, if the share price declines as hoped and anticipated, buy them back at the depressed price. Then, you give them back to your brokerage and pocket the difference, less any costs and fees.
The process of how to short a stock
To short-sell a stock, here’s the process from start to finish:
- Open a brokerage account and fund it. From here, you must take several actions.
- Apply for margin trading. A margin account permits you to take a loan from your brokerage to buy or, in this case, borrow shares of a stock or other equity. You’ll need to deposit at least $2,000 to trade within a margin account.
- Borrow the stock to short-sell. Once you find a stock to short, you can only enter the short sale if you have account equity equal to 150% of the short position’s value (including 100% of the proceeds generated by the short position and additional margin equal to 50% of the short position’s value) when you open the trade. For example, say you want to short 100 shares of a $50 stock, which would net you proceeds of $5,000. Add on an additional 50% of the short’s value, and you’ll need $7,500 in account equity to initiate the short position. The subsequent margin requirement, after opening a trade, is lower. Short sales will show as negative positions in your account.
- Monitor your account equity. Different brokerages have different requirements but, after opening your margin account and borrowing from your brokerage, you must meet the margin maintenance requirement. At a minimum, the required maintenance margin is account equity (cash and securities) equal to 25% of the value of your margined positions. Individual brokerages can set higher minimums and more stringent requirements than these baselines mandated by federal regulatory agencies. Some stocks carry stricter requirements than others.
- Mind, then close your position. Let’s assume you guessed correctly. The $50 stock you shorted plummets in value to $25. To close the trade, you buy back the shares at $25, then immediately return them to your brokerage, pocketing the profit of $25 per share ($2,500 on the 100-share short sale), less any commissions and fees. At the end of the month, your brokerage will charge interest on the margin loan you used to borrow the shares.
That’s how a short sale looks when everything goes right. However, we called the strategy complicated because things can go wrong — sometimes, very wrong.
Risks involved in short-selling
The biggest risk when you short-sell a stock is that it rises in value.
When you buy a stock, you know the precise extent of your risk. Purchase 100 shares of a $50 stock that drops to zero, and you’re out $5,000.
When you short a stock, your risk is literally limitless. That $50 stock can, in theory, run higher forever. As a mild example, assume it rises to $60. You want to close the 100-share short position. So you buy the shares back for $60, meaning you have to pay $1,000 (the upside from $50 to $60 on 100 shares) to exit. The math on a stock that goes up more aggressively is nothing short of terrifying.
If a short position moves in the wrong direction and your account equity drops below your brokerage’s margin maintenance requirements, you might be faced with a margin call. Typically, your brokerage gives you a couple of days to deposit cash or securities in your account or sell positions to raise cash to satisfy the margin call and bring your account equity in line with the margin requirements. If you don’t take action, your brokerage can sell securities in your account on your behalf.
It’s important to note that the law does not require brokerages to give you time, notify you that your equity dropped below the minimum or let you choose which securities to sell to deal with the margin call. They don’t even have to officially announce a margin call before they take action to protect themselves.
Dealing with a short squeeze
A short squeeze occurs when a stock rapidly increases in price, prompting large numbers of short-sellers to buy the stock back to close — or cover — their positions. This often-frenzied buying can help propel the stock even higher, which can lead to even more short covering.
Short squeezes can catch traders by surprise. Sometimes, a stock starts rising for legitimate reasons, such as unexpected news or a surprise earnings report. To deal with a short squeeze, prepare ahead of time by identifying the risk you’re willing to accept.
If you short a stock at $50 and are only willing to absorb losses up to $55, set a buy-stop order to close out your position at — or around — $55. We say “around” because, even though you might set your buy-stop order to trigger when the stock hits $55, you might not get that price, particularly in a short squeeze or other volatile environment.
The ethics around short-selling
Believe it or not, short-selling has been controversial since the 1600s when stock trading was born in Amsterdam. This 2008 article in the “Journal of Business Ethics” touches on that history, if you’re really interested, and neatly packages the ethical arguments for and against short-selling that remain under debate today: “Short sellers not only profit from the misery of others, they also create it through their selling activities. However, they also provide a socially useful service by making prices better reflect true values, protecting other investors from purchasing overpriced securities. Short-sellers can also help to provide liquidity in the markets.”
In a nutshell, short-sellers could be seen as either market manipulators looking only to profit from your losses (because most people tend to buy stocks with the hope they’ll go up) or market warriors helping to expose fraudulent companies in the most extreme cases and keep stock prices in check day to day.
And what’s to stop a deep-pocketed, activist investor from shorting a significant number of shares in a company and then exposing its weaknesses or sowing doubt in the minds of the investing public to drive down the share price and collect a handsome profit?
The problem with naked shorts
One type of short-selling isn’t just unethical, it’s illegal in almost all cases. Naked short-selling is when you short a stock without first borrowing the shares you’ll have to deliver to close the trade. Naked short-selling essentially lets the short-seller skip a key part of the process — initially borrowing shares of the stock they want to short — but still reap profits by acquiring the shares when it’s time to deliver them. This practice can distort supply and demand, particularly on “hard-to-borrow,” heavily shorted stocks, leading to market liquidity issues and further damage to a company’s reputation.
For a long time, naked short-selling was not considered illegal by the Securities and Exchange Commission (SEC) per se, but the following examples helped to usher in closer regulatory scrutiny.
The most recent example of a potential naked short gone wrong occurred with GameStop (GME) shares in 2021 — often referred to as a “meme stock.” Users of the online platform Reddit noticed GME had 140% short interest, which appeared to indicate naked short-selling because it’s not mathematically possible for more than 100% of a company’s outstanding shares, or float, to be borrowed for short sales. These individual investors used memes and viral messaging to spur anger against short-sellers, igniting a rally in GameStop shares that forced anyone short to cover their positions, triggering a massive short squeeze that caused the stock to soar roughly 1,700% between January 8 and 29, 2021. While the SEC found no evidence of naked short-selling, it ultimately chalked up the frenzy to benign market irregularities.
Perhaps the classic example of a successful short — but with catastrophic consequences — was documented in Michael Lewis’s book “The Big Short” and a film adaption of the same name. It tells the story of a small group of investors who foresaw the 2007-08 financial crisis and made heavy bets against a bubble forming in the US housing market, as well as bets against the US economy. The subsequent banking crisis hastened the collapse of leading investment bank Lehman Brothers and others and led to increased oversight of naked short-selling by the SEC.
Costs and associated fees of short-selling stocks
As noted, you pay margin interest on the loan your brokerage extends to borrow shares to short.
You’ll also pay a cost-to-borrow fee, which is typically calculated by multiplying the market value of the short position by the broker’s fee rate, divided by 360; however, the rate can be much higher on heavily-shorted stocks, which are often more difficult to borrow. This fee, which your brokerage includes in your margin balance, can change in a short time based on supply and demand as well as other factors.
As a short-seller, you don’t receive any dividend payments the stock you’re shorting pays. The reality is just the opposite. You pay the dividends distributed during your short position to the owner of the stock you’re short. Your brokerage will deduct these payments from your account.
Alternatives to short-selling stocks
The most straightforward alternative to short-selling stocks is to use stock options, particularly put options, to profit from anticipated weakness. While other, more complex options strategies exist to mimic a short sale, the easiest to understand and execute with limited risk, relative to short-selling, is to simply buy a put option.
Frequently asked questions (FAQs)
As indicated, short-selling can lead to short squeezes and skepticism around heavily shorted companies. This can trigger downside in a stock, potentially hurting a company’s shareholders. On the other hand, research suggests that short-selling can also make the stock market operate more efficiently by helping regulate prices.
Check before opening an account to be sure because some brokerage platforms, such as Robinhood, do not allow short-selling. But most brokerage platforms permit short-selling as long as you qualify for and open a margin account and meet margin account requirements.
The main risk of short-selling is unlimited loss potential. These losses can pile up fast when a stock moves higher quickly. This can lead to a margin call, which can negatively impact your portfolio beyond the short position in question.
