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How Can Short Selling Make Money?
Short selling is a way to make money on stocks for which the price is falling. It’s also referred to as “going short” or “shorting.” An investor borrows a stock, sells the stock, then buys the stock back to return it to the lender.
It’s an advanced strategy that only experienced investors and traders should use. Short sellers are wagering that the stock they’re shorting will drop in price. The short seller buys it back at a lower price and returns it to the lender if the stock does drop after the short sale. The difference between the sell price and the buy price is the short seller’s profit.
Key Takeaways
- Short sellers are wagering that a stock will drop in price.
- Short selling is riskier than going long on a stock because there’s no limit to the amount you could lose.
- Speculators short sell to capitalize on a decline. Hedgers go short to protect gains or to minimize losses.
- Short selling can net the investor a decent profit in the short term when it’s successful because stocks tend to lose value faster than they appreciate.
- Inexperienced investors may find that short selling stocks isn’t to their advantage.
Example of a Short Sale
Suppose an investor thinks that Meta Platforms Inc. (META), formerly Facebook, is overvalued at $200 per share and that it will decline in price. The investor could “borrow” 10 shares of Meta from their broker and then sell the shares for the current market price of $200.
The investor could buy back the 10 shares back at $125 if the stock goes down to this price and return the borrowed shares to their broker. They would net $750 ($2,000 – $1,250). But the investor would lose $500 ($2,000 – $2,500) if Meta’s share price instead rises to $250.
What Are the Risks?
Short selling amplifies risk. An investor stands to lose only the money that they’ve invested when they buy a stock or “go long.” The maximum the investor could lose is $200 if they bought one Meta share at $200 because the lowest value that any stock can fall to is $0.
But an investor can lose an infinite amount of money when they short sell because a stock’s price can keep rising forever. An investor would lose $175 per share if they had a short position in Meta and short sold it and the price rose to $375 before the investor exited.
Another risk faced by short sellers is a short squeeze in which a stock with a large short interest climbs rapidly in price. The stock that has been heavily sold short. This triggers 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.
Short Squeeze
Followers of WallStreetBets, a popular Reddit page, banded together in January 2021 to cause a massive short squeeze in the stocks of struggling companies with very high short interest, such as video game retailer GameStop Corp. (GME). This caused the company’s share prices to soar 17-fold in January alone.
Short selling can generally only be undertaken in a margin account, a type of account by which brokerages 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.
The trader will have to pump additional funds into the margin account right away if the stock they’ve sold short suddenly spikes in price. This might happen if the company announces in its quarterly report that earnings have exceeded expectations. The brokerage might otherwise forcibly close out the short position and saddle the trader with the loss.
There’s no limit to the amount they could lose when an investor shorts a stock because the stock can continue to go up in value indefinitely. Investors could even end up owing their brokerage money in some cases.
Why Do Investors Go Short?
Short selling can serve the purposes of 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.
Institutional investors and savvy individuals frequently engage in short selling strategies for both speculation and hedging simultaneously. Hedge funds are among the most active short sellers and they often use short positions in select stocks or sectors to hedge their long positions in other stocks.
Short selling presents investors with an opportunity to make profits in a declining or neutral market, but only sophisticated investors and advanced traders should attempt it due to its risk of infinite losses.
When Does Short Selling Make Sense?
Short selling isn’t a strategy used by many investors because the expectation is that stocks will rise in value over time. The stock market tends to go up in the long run although it’s occasionally punctuated by bear markets in which stocks tumble significantly.
Buying stocks is a less risky proposition than short selling for the typical investor with a long-term investment horizon. Short selling may only make sense in certain situations, such as in a protracted bear market or if a company is experiencing financial difficulties. Only advanced investors who have a high tolerance for risk and understand the risks associated with short selling should attempt it.
A Less Risky Alternative to Short Selling
An alternative to short selling is to buy a put option on the same stock. This limits your downside exposure. Holding a put option gives an investor the right but not the obligation to sell the underlying stock at a stated price called the strike price. The investor’s loss is limited to the amount paid for the put option if the price of the stock in question rises rather than falls. This is referred to as the option premium, plus any commissions.
The option premium will vary based on the strike price and the expiration date of the put option. The higher the strike price is and the longer into the future the expiration date is the higher the option premium will be.
Meta was trading at about $200 on March 4, 2022. A put option with a strike price of $200 expiring on March 18, 2022 cost about $13 per share in terms of option premium plus commissions at that time. The investor’s loss would be limited to $13 per share plus commissions if the price of Meta actually rose above $200.
Costs Associated With Short Selling
Trading commissions aren’t the only expense involved when short selling. There are other costs as well, including:
- Margin interest: Short selling can generally only be undertaken in a margin account so the short seller has to pay interest on the borrowed funds.
- Stock-borrowing costs: Shares of some companies may be difficult to borrow due to high short interest or limited share float. The trader must pay a hard-to-borrow fee to borrow these shares for short selling. It’s based on an annualized rate that can be quite high and is prorated for the number of trades that the short trade is open.
- Dividends and other payments: A 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. These can include stock splits and spinoffs.
What Is the Maximum Profit You Can Make From Short Selling a Stock?
The maximum profit you can make from short selling a stock is 100% because the lowest price at which a stock can trade is $0. But 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’ve Invested in a Short Sale?
Yes. Your losses can be infinite. This is the reverse of a conventional long strategy by which the maximum gain on a stock you’ve purchased is theoretically infinite but the most you can lose is the amount invested.
An investor who had a short position of 100 shares in GameStop as of Dec. 31, 2020 would have been faced with a loss of $306.16 per share or $30,616 if the short position had still been open on Jan. 29, 2021. The stock soared from $18.84 to $325.00 over this one-month period so the investor’s return would be -1,625%.
Is Short Selling Bad for the Economy?
Short selling has acquired a negative reputation because some unscrupulous short sellers have used unethical tactics to drive down stock prices. But short selling facilitates the smooth functioning of financial markets when it’s used correctly because it provides market liquidity. It acts as a reality check for investors’ unrealistic expectations and reduces the risk of market bubbles. It enables downside risk mitigation.
What Is a Margin Call?
You’re using money borrowed from your broker as well as your own money when you trade on margin. It triggers a margin call if your equity in the margin account or the percentage of the assets in the account that you own falls below a specific level.
You would have to deposit more funds or securities into the margin account in this case or you could choose to sell some of your assets. Your broker may require you to sell securities at market price to meet the margin call if you don’t deposit the necessary funds. You may be subject to a margin call as losses start to accumulate in your margin account if a stock that you sold short goes up in value.
The Bottom Line
You can make a healthy profit short selling a stock that subsequently loses value but you can rack up significant and theoretically infinite losses if the stock price goes up instead.
Short selling also leaves you at risk of a short squeeze when a rising stock price forces short sellers to buy shares to cover their position. This causes prices to spiral even higher. Short selling may not be the best strategy for inexperienced traders and investors because of these elevated risks.