Short Selling: How to Short a Stock

Short selling is when an investor borrows shares of a stock to sell them at the current price in the hopes of buying those shares back at a lower price in the future. The investor then pockets the difference as profit.

The two main reasons an investor might be interested in shorting a stock are to either profit from downward price pressure or to hedge an existing long position.

If a stock's price depreciates rapidly, investors who are short stand to make a lot of money in a short timeframe. This provides a way to profit in a bear market as well as from individual stocks suffering negative news or sentiment.

Short selling a stock can seem complex, but by following these steps, you can understand the process and approach it confidently.

Step 1: Open a margin account with your broker

To short a stock, you’ll need a margin account rather than a regular cash account. A margin account allows you to borrow funds from your broker to execute trades. Most brokers require you to meet specific criteria, such as a minimum account balance, and will have you sign a margin agreement outlining the risks involved. Once you’ve qualified for a margin account, you’ll be ready to begin opening short positions.

Step 2: Select the stock you want to short

Research and identify a stock you believe will decline in price. Analyze financial reports, market trends, and news that might negatively affect the stock’s performance. Various informational newsletters and subscription services are also available for new investors to gain access to reliable market data and expert insights. Note that not all stocks are available for shorting due to restrictions or low availability.

Step 3: Enter a short sell order

Once you’ve chosen a stock, place a short sell order through your brokerage platform. This tells your broker to borrow and sell the shares on your behalf. You’ll see the proceeds from this sale deposited in your account, but you still owe the borrowed shares.

Step 4: Monitor the position

After the short sale is executed, keep a close eye on the stock price and market conditions. If the price drops, you can buy back the shares at a lower cost, making a profit. However, if the price rises, your losses can grow quickly, and you may consider closing out your position before losing more.

Step 5: Close the short position (Buy to Cover)

To close your short position, you must 'buy to cover.' This means purchasing the same number of shares you initially borrowed and returning them to your broker. You keep the difference as profit if you buy the shares for less than the original sale price. If the price has risen, you’ll incur a loss.

Step 6: Account for fees and interest

Short selling comes with fees and interest charges. You’ll typically pay a fee for borrowing the shares, and interest may be incurred if you hold the short position for an extended period. Make sure to factor these costs into your overall profit or loss calculations. Depending on circumstances and how long you borrowed the shares, it's entirely possible to still come out net negative after accounting for fees and interest despite successfully shorting a stock that dropped in value.

An example of short selling

In early 2020, some investors believed Tesla’s (NASDAQ: TSLA) stock price was overvalued. Concerns about competition from other electric vehicle makers, production delays, and the company’s high valuation led many traders to think the stock would decline.

Suppose an investor decided to short Tesla when the stock was trading at $300 per share. They borrowed 100 shares from their broker and sold them immediately, receiving $30,000 (100 shares × $300 per share).

The investor aimed to buy back the shares later at a lower price to return them to the broker. If Tesla’s stock price fell to $200 per share, the investor could buy 100 shares for $20,000, return them, and pocket the $10,000 difference (minus fees and interest).

However, if Tesla’s stock price rose instead — say to $400 per share —the investor would have to buy 100 shares for $40,000 to close the position. In this case, they’d lose $10,000 in addition to any fees or interest owed.

This example shows both the profit potential and the significant risk involved in short selling, especially since losses are theoretically unlimited if the stock price keeps rising.

Alternative ways to short a stock

Other vehicles by which investors can short a stock include put options and inverse ETFs. Put options are contracts that give an owner the right, but not the obligation, to buy 100 shares of a stock at a specific price on or by a certain date. If the price of the underlying stock declines, the put option should increase in value. However, options are complicated, risky investment tools and involve many variables beyond the underlying asset's price. Sometimes, options may not appreciate in value even when the underlying stock moves in the desired direction.

Inverse ETFs, available for many different asset classes, might be the simplest way to open a short position against a stock, commodity, or index. An Inverse ETF aims to provide returns in the opposite (inverse) direction of an asset. They often provide leverage as well, seeking to return 2x or 3x the inverse price of the asset. These ETFs are high-risk and designed for experienced traders and, depending on the rebalancing strategy of the ETF, might only be appropriate for day trading.

As you may have gathered by now, short selling is a risky strategy best suited for experienced investors only. Before shorting a stock, several factors are worth considering.

Brokerage requirements

As mentioned, short selling requires a margin account, which allows you to borrow shares from your broker. To qualify, you typically need to:

• Maintain a minimum account balance (often $2,000 or more).
• Agree to margin rules and terms.
• Understand that brokers can issue a margin call if your account value drops below a required maintenance level, forcing you to deposit more funds or close positions. Depending on its policies and the situation, a broker might liquidate other securities in your account without prior notice to cover the margin deficiency. All positions in a margin account can be collateral to a loan from the broker.

Ensure you know your broker’s specific rules before initiating a short sale.

Fees and costs

Short selling involves several costs in addition to the initial trade, including:

• Borrowing fees: You’ll pay a fee to borrow the shares, which varies based on the stock’s availability and demand. Stocks with high short interest can have higher fees.
• Interest on margin: Because you’re borrowing shares on margin, interest accrues over time. Holding a short position for long periods can increase these costs significantly.
• Dividends: If the company pays a dividend while you’re shorting the stock, you’re responsible for paying that dividend to the lender of the shares.

Factor these fees into your profit and loss calculations to ensure short selling remains cost-effective.

Risk of unlimited losses

When you short a stock, your potential losses are theoretically unlimited. If the stock price rises sharply, your losses can exceed the amount you initially invested. This differs from buying stocks, where the maximum loss is limited to your investment amount (if the stock goes to zero).

Market volatility and short-squeezes

Stocks with high short interest can be prone to short squeezes, where rising prices force short sellers to close their positions by buying back shares, further driving up prices. Market volatility can amplify these risks, making it important to monitor positions closely and use stop-loss orders to limit potential damage.

Ethical and regulatory concerns

Short selling is legal in most markets, but it has faced ethical scrutiny, especially during economic downturns. Critics argue that short sellers can amplify market declines, while supporters claim short selling helps uncover overvalued companies and promotes market efficiency.

Additionally, regulators sometimes impose temporary bans on short selling during extreme market stress to stabilize prices. Make sure you’re aware of any regulations that might impact your trades.

Your investment knowledge and risk tolerance

Short selling is a more advanced trading strategy. Before you begin, ensure you fully understand the mechanics, risks, and costs. Consider whether short selling aligns with your overall risk tolerance and investment goals. If you’re new to shorting, starting with small positions and practicing risk management strategies is a prudent approach.

By keeping these considerations in mind, you can make informed decisions and better manage the challenges that come with short selling.

When investors rush to close their short positions to avoid significant losses, stocks with substantial short interest can sometimes see their prices soar dramatically, a scenario referred to as a 'short squeeze.' A short squeeze occurs when a stock begins ticking higher, causing some investors to close out their short positions. As these investors buy back shares, this leads to an even higher price, which in turn causes other investors who have shorted the stock to do the same. Those who failed to close out their positions early stand to lose significant sums of capital.

Short squeeze example: The GameStop Short Squeeze of 2021

In early 2021, GameStop (NYSE: GME) became the center of one of the most famous short squeezes in recent history. Many hedge funds and institutional investors believed the video game retailer’s declining business model would cause its stock price to fall. They heavily shorted the stock, expecting to profit as its price dropped.

However, retail investors from online communities, particularly Reddit's r/WallStreetBets, noticed how heavily shorted GameStop was. They began aggressively buying shares together, driving up the price. As the stock suddenly soared, short sellers were forced to close their positions to limit their losses, which required them to buy back shares at higher prices. This additional buying pressure pushed the price even higher — a classic short squeeze.

GameStop’s stock skyrocketed from around $20 per share in early January to an all-time high of $483 by the end of the month. The squeeze led to massive losses for some hedge funds.

This well-known, and relatively recent, example highlights the risks of short-selling when bullish momentum ensues.

Simply put, you should short a stock when you have good reason to believe the share price is set to fall. There could be many reasons for this, both technical and fundamental.

Here are some scenarios and indicators to consider when deciding whether or not to short a stock.

When you believe a stock is overvalued

One of the primary reasons to short a stock is when you believe it’s trading at a price higher than its actual value. This can happen when a company’s stock price has been driven up by hype, speculation, or unrealistic growth expectations.

Some potential signs of overvaluation include:

• High price-to-earnings (P/E) ratio compared to industry peers.
• Declining earnings or revenue despite a rising stock price.
• Excessive media attention or investor excitement not backed by fundamentals.

During company-specific trouble

Shorting a stock could be profitable if a company faces significant challenges, such as legal issues, management scandals, or declining market share. Negative news or poor financial performance often leads to a drop in a stock’s price.

Some common examples of company troubles include:

• Product recalls or failures.
• Management changes due to misconduct.
• Negative earnings reports or reduced guidance.

Weak or declining sectors

Some sectors are more prone to downturns based on economic conditions or shifts in market trends. Common sectors that traders short during economic uncertainty include:

• Retail: Brick-and-mortar retailers are struggling against e-commerce competition.
• Energy: Oil and gas companies can be vulnerable during periods of falling energy prices or when renewable energy gains momentum.
• Technology: Overvalued tech stocks can be shorted when growth slows or interest rates rise, times in which many investors see risk assets as less attractive.

Using technical analysis indicators

Technical analysis can help identify potential shorting opportunities based on price patterns and market trends. Some commonly used indicators for short sellers include:

• Relative Strength Index (RSI): An RSI above 70 indicates a stock may be overbought and due for a pullback.
• Moving Averages: If a stock’s price falls below its 50-day or 200-day moving average, it can signal a bearish trend.
• Head and Shoulders Pattern: This reversal pattern suggests that a stock’s upward trend is weakening and may soon decline.

The above includes only a small sample of many different bearish technical indicators. I find it wise to use multiple indicators together. When several technical analysis (TA) trends converge, it tends to provide a stronger signal, giving greater confirmation of a possible trend.

When market sentiment is excessively bullish

Extreme optimism can sometimes drive stock prices higher than justified by fundamentals. When market sentiment seems irrationally positive, it may be an opportunity to short. This is often called a contrarian strategy, where you bet against the crowd.

Some warning signs of excessive optimism include:

• A surge in social media hype or speculative trading activity.
• Parabolic price increases over a short period without underlying news.
• Extreme greed, as measured by the Fear and Greed Index.

Advantages of short selling

Short selling offers unique opportunities in the market, allowing you to profit during downturns, hedge your portfolio against losses, and expose overvalued or poorly performing stocks. These strategies contribute to market efficiency and can be lucrative when paired with thorough research and solid risk management. Remember, no single indicator should dictate your decisions — stay vigilant and diversified to protect your investments.

As with any investment strategy, managing risk is key. Short sellers who fail to manage risk properly can face significant losses.

Here are some key ways to mitigate the substantial risks of shorting a stock.

Hedging

Hedging involves balancing your short position with a long position to reduce potential losses. For example, if you short a specific stock, you might buy a call option on the same stock. If the stock price rises, the gains from the call option can help offset losses from your short position. Hedging helps limit downside risk and provides a safety net if the market moves against you.

Example: If you short XYZ Corp at $100 per share, you could buy a call option with a $110 strike price. If XYZ’s price jumps to $120, your short position loses $20 per share, but your call option gains approximately $10 per share (not accounting for factors like time decay and implied volatility), reducing your net loss.

Using stop-loss orders

Stop-loss orders automatically close your short position if the stock price reaches a predetermined level. This limits your potential losses by ensuring you exit the trade before losses grow too large. It’s a disciplined way to protect your investment from sharp, unexpected price increases.

Example: If you short a stock at $50 per share, you might set a stop-loss order at $55. If the stock price rises to $55, your broker automatically buys back the shares, capping your loss at $5 per share.

The only potential downside to using stop-loss orders is that sometimes stocks experience sudden price reversals before resuming an overall trend, leading traders to get “stopped out” of what would have otherwise been a winning position in the long run.

Sizing your position wisely

Be cautious with the size of your short position relative to your overall portfolio. Risking too much on a single short trade, or any trade for that matter, can be disastrous. A common approach is to limit short positions to a small percentage of your total investment capital, such as only 5% to 10% or less.

Example: If your portfolio is worth $10,000, you might limit a short position to $500 or $1,000 to avoid excessive risk. Note that for this strategy to be effective, it must be combined with a stop loss because shorting can lead to unlimited losses.

Regularly monitoring your position

Short selling isn’t a “set it and forget it” strategy. Market conditions can change quickly, so keep a close eye on your positions, stock news, and broader market trends. Being proactive lets you adjust your strategy or exit the trade if risks increase.

By combining these strategies, you can better manage the risks of short selling and protect yourself from the large losses that can result. While short selling offers profit opportunities, a thoughtful approach to risk management is key to long-term success.