Investing in the stock market means buying shares and holding onto them until they go up.
But there’s another way to profit when a stock goes down called “shorting a stock”. Shorting can be a powerful tool for experienced traders but it’s also a high risk strategy that requires understanding and execution.
How Does Shorting Work?
Short selling, or “shorting”, means borrowing shares of a stock from a broker, selling them at the current price and buying them back at a (hopefully) lower price later on. The goal is to profit from the stock going down.
For example, if a stock is at $50 per share, an investor might borrow and sell the stock at that price. If the stock goes down to $40, the investor can buy back the shares, return them to the broker and pocket the $10 per share (minus any fees).
This is attractive to traders who think a stock will go down or want to hedge their portfolio. It’s also a way to express a bearish market view or take advantage of overvalued stocks.
What are the Risks of Shorting?
The risks of shorting are big, starting with the risk of unlimited losses. Unlike buying a stock where the maximum loss is limited to the amount invested, shorting exposes you to infinite losses because a stock can theoretically go up infinitely. For example, if you short a stock at $50 and it goes to $200, you would have to buy it back at the higher price and lose $150 per share.
Another big risk is the margin account requirement where you borrow funds from your broker to short a stock. If the stock moves against you, you may get a margin call and have to deposit more funds or close your position at a loss.
Also, short squeezes can happen when a heavily shorted stock goes up and short sellers have to buy back shares to limit their losses. This buying activity can make the stock go up even more and you’ll lose even more. Borrowing costs are also part of the equation.
Short sellers have to pay fees or interest to borrow the stock from their broker. If the stock is in high demand for shorting, these borrowing costs can get very high and reduce overall profit.
Real-World Example: The GameStop Saga
A well known example of shorting is the GameStop stock in early 2021. Many hedge funds had shorted GameStop thinking the stock would go down. But a group of retail investors banded together and bought GameStop shares and the stock went up and triggered a huge short squeeze.
They had to buy back shares at much higher prices and lost billions. The GameStop saga proves shorting is a risk and heavily shorted stocks are unpredictable.
Is Short Selling Ethical?
Short selling is a bit dodgy.
Critics say it can lead to unethical behaviour, like spreading false info to bring down a stock’s price — aka “short and distort”. While illegal, it’s hard to catch.
On the other hand, short sellers say it’s a vital part of the market’s balance. By finding overpriced stocks, short sellers can provide liquidity and pop bubbles, so prices correct to the stock’s true value.
What are other alternatives to Short Selling?
If short selling feels too risky, you can try other ways to profit from falling stock prices with less exposure.
One common alternative is buying put options. A put option gives you the right (but not the obligation) to sell a stock at a set price within a time frame. This way you can profit from a falling stock price without the unlimited loss of short selling. Try it out with a day trading simulator.
Another option is inverse ETFs which increase in value when the market or a sector falls. These funds can hedge against downturns without the complexity of shorting individual stocks.
Try these out and you can achieve similar results with less risk. Worth a look if you’re new to bearish trading.
Is Short Selling for You?
Short selling lets you profit from falling stock prices but it’s not for the faint of heart. Unlimited losses, market volatility and short squeezes make it a strategy for experienced investors only.
Whatever your reason for short selling, be careful and have a plan. The market is crazy and planning is key.