The financial markets offer opportunities for buyers and sellers. Shorting is an investment thesis or trading strategy that can be ideal for participants speculating on price drops in the stock market. In other words, short sellers benefit from a falling stock price.
Many experienced traders and investors bet on a decline in prices for specific equities, going against bullish investors and potentially profiting from a fall in the market.
Shorting a stock is a good idea for any investor who has a strong belief that an asset will decline in its share price, but it is not always straightforward and relies on various factors that impact not only the stock but the market in general.
What Does Shorting a Stock Really Mean for Investors?
Shorting a stock or short selling is an investment strategy where traders assume a fall in the price of a particular equity. The strategy may be used as simple speculation or to hedge against the downside risk of a long position by selling the same security or one in a similar field.
You short a stock when you borrow shares of a stock or asset, believing the stock price will decline in value. The investor will sell these borrowed shares to buyers willing to pay the market price. However, before returning the shares, the short seller is betting that the price will decline, and they can then purchase them at a lower cost.
This process can usually be done through a broker-dealer, and shares must be borrowed as an individual cannot sell shares that do not exist.
However, the potential risk of a loss is endless as an asset can increase significantly. For example, during the GameStop short squeeze, investors shorting shares of the company realized considerable losses. As a result, shorting a stock has a high-risk, high-reward profile, presenting the ability to achieve significant profits as well as astronomical losses.
To short a stock, you must have a margin account. Margin allows stock investors to open positions, but it is likely while their position is open, they must pay interest on the shares borrowed.
Brokers have set regulations that require a minimum value the margin account must have. If the trading account falls below its value, more funds are needed, or the position risks being sold. Margin trading comes with immense risk, so it is wise to manage risk responsibly.
Stock Shorting Example
If you feel the stock market will decline and decide to short shares of Apple, you may enter a short position and borrow 100 shares at $150, costing $15,000. Then, you can sell them to a buyer, and purchase them back at a lower price (if they decline), such as $140.
If this occurs, you can purchase the shares back for $14,000 and make a profit of $1,000. However, if Apple rises from $150 to $170, you will have to spend $17,000 to repurchase the borrowed shares if you need to close the position, resulting in a $2,000 loss. Stop orders can be in place to help mitigate risk, but they are not guaranteed.
Why Short a Stock?
The reasons to short a stock are almost identical to the reasons to buy a stock — speculation in the price of an asset. However, speculation is not the only option, as many large companies and investors sell short for hedging.
Speculators make assumptions that the stock value of an asset will decline. The reason speculators choose to short a stock on the open market is for profit. Investors may see a company or equity as overvalued and believe its price is above where it should be. Therefore, the individual can sell in an area where the price seems more accurate.
Meanwhile, investors may also look to capitalize on the potential decline of an industry. While the market may be trading higher, a specific sector may seem weaker in comparison, and an opportunity could arise.
Speculators will look into the financials and fundamentals of a business and make an informed decision. For example, comparing a company's recent financials to competitors or its past performance helps decide whether shorting a stock is ideal. A firm's financials fluctuate each year, and a weaker performance can lead to an increase in short sellers.
Fundamentals help distinguish between a positive business and an unhealthy business. For example, investors can compare fundamentals such as profitability, assets, liabilities or growth potential. These indicators can help differentiate a buy or sell.
Hedge funds are among the most common short sellers in the industry. They often use short positions in select stocks to hedge against their long positions.
With inflation surging in the current economic climate, a short sale may be appropriate for a specific industry. High inflation can be attributed to factors such as increased household demand, supply chain shortages and a strong labor market.
To control inflation, the Fed raised interest rates, causing a rise in mortgage rates. A resulting decline in housing demand could impact the real estate market. As a result, a retail investor of hedge funds could be enticed to short a stock in that industry.
Hedging is another form of shorting a stock and is usually done to offset the risk of losses in current investments. This practice involves investors taking an opposite position to their assets to reduce losses. However, it can also reduce profits.
Short selling is not a strategy all investors use as it comes with a significant level of risk. There is an expectation that, over the long run, stocks will rise and the market will steadily increase in value.
Investors can track a stock's overall sentiment through short-selling metrics. For example, a metric such as the short interest ratio (SIR) measures the proportion of currently shorted shares compared to the number of shares available. A high SIR can signal an overvalued stock.
Bullish runs can occasionally be impacted by bear markets where stocks tumble considerably. These situations are the best times to short a stock, but risk is still at play.
Benefits of Shorting a Stock
Many of the reasons to short a stock are similar to the reasons to purchase a stock. Investors are constantly speculating on the potential value of a firm. You can find several benefits of shorting listed below.
Potential for High Profits
Shorting a stock comes with a higher risk than buying a stock. However, this still leaves room for potentially significant gains to be achieved. As a result, If you can accurately predict a fall in price, you leave yourself open to a substantial return on investment.
Hedging
Hedging strategies can offset the high risks associated with shorting a stock. If done correctly, hedging is the perfect technique to avoid those increased costs, and you can counterbalance your current holdings.
Limited Capital Needed
Not much capital is required to get you started. It can be done through a brokerage firm, and using a margin account provides a trader with leverage, ensuring the trader does not need a substantial amount of capital.
More Opportunity
Being able to trade during downtrends and short a stock doubles your profit opportunities. Not only can you make money from buying but also through selling shares. It provides more opportunities to profit in times of economic uncertainty.
Protect Your Portfolio
Shorting a stock is another way to protect your portfolio from losses. It offers the opportunity to make money during downtrends, which can offset the losses from your long-term investments. If you are interested, retail investors can use a trading platform like Robinhood to perform a short sale.
Considerations When Shorting Stocks
Shorting a stock has benefits, but no trade is 100% guaranteed, and there will always be things an investor should consider. Here are some of the things you should remember before shorting a stock.
Unexpected News
Every public company releases its earnings or significant announcements to the public. A positive earnings release can have a positive reaction from investors. Unexpected releases can leave your short sell at risk of a considerable loss, so be aware of a company's upcoming events.
Short Squeeze
Choosing to short a stock leaves you at risk of a short squeeze. A short squeeze occurs when an unusual condition triggers a sharp rise in the price of a stock. The price jumps unexpectedly, and sellers can lose a significant proportion of funds. A risk as substantial as this must be considered when entering into a short.
Wrong Timing
A company may be overvalued, or its recent earnings may have disappointed investors. However, it may still take a while to see a sudden fall in its price, and this can leave a short seller vulnerable to margin calls and losses. Short sale timing is key for investors, and it can be difficult to pinpoint a decline in a stock.
Against the Trend
History dictates that stocks tend to trade in an upward trajectory. Therefore, over the long term, stocks appreciate, and shorting a stock is betting against the market. This means participants are going against historical trends.
Borrowing Money
To short a stock, you must open a margin account, which enables you to borrow money from the brokerage. Borrowing money can leave you vulnerable, and it is easy for losses to go beyond your margin. As a result, you may be susceptible to a margin call and forced to add additional funds to liquidate your position.
Costs
If you decide to short a stock using a margin account, you will likely face costs along the way. Short selling involves high costs, unlike buying and holding investments. Margin interest can be a significant expense, as the interest paid on short trades can add up over time.
Borrowing costs can occur for shares that are difficult to borrow because of high short interest or any other reason. These fees can be substantial, and it is difficult to determine how much will eat away at your investment.
Compare Short-Selling Brokers
Various brokers offer the option to short a stock, making it a widely available investing or trading option for many investors. However, finding the best brokers to short a stock is crucial, and not every broker will meet your requirements. You can find some of the best brokers for short selling listed below.
Proper Timing and Research
Shorting a stock can be a beneficial investment approach despite the risks and considerations involved. It offers the potential for high profits, hedging opportunities and more trading opportunities during downtrends. However, careful evaluation of timing, historical trends, borrowing money and costs is necessary. Proper research and understanding of the market and individual risk tolerance are essential before making a decision to short a stock.
Frequently Asked Questions
Is shorting a stock legal?
Shorting a stock is legal. It is a strategy used by numerous investors over the years and can be undertaken by anyone with a margin account.
How do you tell if a stock is being shorted?
Yes, you can tell if a stock is being heavily shorted, and you can find general information about short sales of a company’s stock on various websites, which will also provide a general background and overview of the stock’s current performance. Alternatively, you can find a list of the most shorted stocks here.
Is short selling bad?
Short selling is not necessarily bad, but it can be risky and controversial. It involves borrowing stocks from a broker and selling them in the hopes of buying them back at a lower price and making a profit. Short selling can be used to hedge against market downturns or to bet against a specific company. However, it can also lead to market manipulation and exacerbate market volatility. It is important to thoroughly research and understand the risks before engaging in short selling.
About Sam Boughedda, Stock Market Analyst
He is an expert in the following spaces: stock market news writing, analysis, and research.