How to Short a Stock: A Beginner’s Guide to Short Selling
You might’ve caught a headline recently that got you thinking about how to short a stock. Maybe a headline like this one from Business Insider: Traders betting on stock declines made $344 billion in just one month as coronavirus ravaged the market. Making that kind of money when most people are losing 20% to 30% of their portfolio is an appealing prospect. And one of the ways it’s possible is via short selling.
What Does It Mean to Short a Stock?
Shorting a stock is about betting against it. If you open a short position in a company or an index, you’re betting that the value of that security is going to decrease. Short selling is only profitable if the value of the stock drops below the price of your short position. If it does, you profit on the difference when you close that position.
While traditional investing involves making money on the appreciation of securities, short selling is the inverse. Savvy investors know the market can’t always go up. So they recognize overvalued companies and short them strategically. Their foresight can result in profits while everyone else incurs losses.
Borrowing to Sell, So You Can Buy It Back
How do you short a stock? Because you’re banking on the security losing value instead of gaining it, the investment process works a bit differently. You’re not actually purchasing a stake in the security – you’re borrowing it.
Short selling has two parts: selling to open and buying to close. You open your short position on a sale of the stock and buy the security back to close it. Another way to think about this is as the reverse of a normal investment – you’re selling the security first, then buying it back at a cheaper price. Let’s look at an example:
Mark believes the share price of XYZ Company will fall from $100 over the next month. He opens a short position by borrowing 20 shares from his broker and sells them. He is now “short” 20 shares ($2,000). A month later the stock price for XYZ Company is lower, at $80! Mark closes his short position by buying 20 shares at $80 ($1,600) and returns them to his broker. The $400 difference is his profit, not accounting for fees and interest.
A short position can stay open indefinitely. Unlike traditional investing – which involves lower risk over a longer time horizon – short positions tend to accumulate risk the longer they’re open. There’s also interest fees from the broker to consider, which add up. All in all, it’s advantageous to close a short position as quickly as possible.
Beware the Cons of a Bad Bet!
Take a moment to realize that while there’s money in short positions, there’s also risk. You don’t make money in a declining market without taking on proportionate risk! Before you open up a short position in a company or index, make sure you know what you’re doing.
Most of the risk in short selling comes when a security increases in value, rather than decreases. Not only do you lose any profit, you now owe the difference between what you sold the stock for and the cost of buying it back to return to your broker. Here’s an example:
Mark opens another short position with XYZ Company. He believes the share price will continue to fall from $80 over the next month. He borrows another 20 shares from his broker and sells them. He’s short 20 shares ($1,600). A month later, the stock price for XYZ Company is higher, at $100! Mark closes his short position, paying $2,000 for 20 shares at market value. This time, he’s out the $400 difference, along with fees and interest.
The big issue with short selling is that gains are finite, but losses are infinite. If you short a stock, you’ll make money as long as the share price drops. And the farthest it can drop is to $0.00. But there’s no limit to how high the price of a stock can climb. If your bet on a short goes the opposite direction, you’re on the hook for a lot more than your initial investment.
Do Your Research Before Shorting a Stock
Shorting a stock seems like a simple concept, but there’s a lot of nuance that goes into properly setting up and capitalizing on a short position. In fact, you need to have a margin account to short stocks, and most brokers have stringent qualifications for setting one up. There are also interest charges to worry about, since you’re effectively borrowing from your broker to facilitate a short.
Short selling is popular during times of economic turbulence, market corrections and in bear markets. It’s often a bet that bad things will get worse or that overvalued securities will track back to a normal valuation. Whatever your thesis behind a short position, make it with confidence and prepare to accept the risk as well as the reward.
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