Would you like to take advantage of the guesswork that a stock is about to fall? Selling short may sound like a compelling option.
Selling short is one of the few ways to make money even when a stock or the market as a whole is declining. Because of this, short selling is a popular strategy for hedge funds looking to generate positive returns in all market environments.
But before you When getting into this active trading strategy, it is important to understand how short selling works and why it is a risky way to make money in the stock market. Here’s what you need to know.
What is Short Selling?
Short selling is a short-term stock trading strategy that makes money when a stock falls in price. This happens when an investor borrows shares from another investor who owns the shares.
The borrower (i.e. short seller) pays a fee as well as interest until the shares are returned. The borrower then immediately sells the stock to another buyer.
To close the position, the short seller buys back the shares and returns them to the lender. Short sellers make money when the stock price has fallen during the holding period. However, you will lose money if the stock price rises during the holding period.
Short sales example
In a theoretical example, borrower Björn borrows 100 XYZ shares from lender Lucy. He borrows the stock at $ 10 per share and sells it on the open market to buyer Bob, who pays $ 10 per share.
Three days later, the price of XYZ fell to $ 7 per share. Borrower Björn buys 100 shares of XYZ from Seller Scott for $ 7 per share. Björn returns the 100 shares to Lucy. On this transaction, Björn made $ 3 per share with a profit of $ 300 (minus the fees and interest he paid Lucy).
Of course, this example has been stylized to show how stocks and money flow in a short sale. In reality, Björn, Lucy, Bob and Scott don’t know each other, and all transactions are electronic.
Is it Risky to Sell Short a Stock?
Short selling stocks have one asymmetrical risk profile. In other words, it offers a good chance of a small uptrend and a small chance of an infinite downtrend. Unlike most forms of investment, short selling can bring negative money to investors.
If the price of a stock falls after borrowing it, the person selling the stock short can make a profit. At best, the share price of the stock would drop to $ 0. In this case, the person who sells the stock short can buy stocks for $ 0 and keep all of the money from the original sale of the stock. In the worst case scenario, however, the investor could go bankrupt.
One example of how risky short selling is is the current GME stock drama (Gamestop). Several well-known hedge funds had already cut Gamestop (GME) in January 2021. At the time, shares were trading for around $ 40 per share.
To “save Gamestop” and thwart investment bankers, private investors joined forces to raise the price of GME. As the price rose, some short sellers bought back their shares to limit their losses. However, this only caused the price to rise even further, resulting in even steeper losses for short sellers who persisted in their short sales. In the investment world, this phenomenon is known as «short squeeze».
At its peak, GME was trading for $ 347.51 per share. This means that the investors who cut the stock could have lost as much as $ 307.51 per share. If the price had been higher, they would have lost even more.
Who should participate in the short sale?
The Gamestop frenzy is a popular example of a failed short. It clarifies how risky it is to bet on something with unlimited disadvantage. The typical investor should not view short selling as a means of making money as it carries significant downside risk with limited upside risk.
This type of «investing» is usually reserved for hedge funds that aim to make money even when stock markets are falling. It is rarely a good idea to compete against the most demanding of investors in a game with an infinite disadvantage.
Because short selling involves asymmetric risk, it is difficult to measure against the averages and standard deviations that are the tools of traditional risk metrics. For more information on this topic, see Skin in the Game by Nassim Taleb.
What tools can I use to practice short selling?
Several companies offer free paper trading apps that allow retail investors to employ all kinds of advanced trading strategies including short selling. TD Ameritrade’s ThinkOrSwim may be the best option for aspiring traders. The Learning Center not only offers «paper money» accounts, but also contains detailed articles on how to execute the trades.
WeBull also offers free stock market simulators. The free virtual trading platform allows users to explore different strategies and take advantage of downside risks.
Both tools give users a clear idea of how risky short selling can be. However, they also give users the option to upgrade to real accounts, which could put users at risk for real money. WeBull only needs $ 2,000 to access its margin accounts at an interest rate of 6.99%. ThinkOrSwim is $ 2,000 and has additional requirements based on stock prices.
How can I short a stock myself?
To sell stocks, you must have a margin account. Most major brokers and several investment apps allow retail investors who have reached a certain minimum balance to have margin accounts.
Remember, margin includes paying interest. And if a position goes down, the broker can make a margin call, which means that you have to deposit more money to cover possible losses. Therefore, short selling (and margin trading in general) is not something you want to do when you are tight on cash.
Both ThinkOrSwim and WeBull allow clients to trade on margins. Likewise, Robinhood and other major brokers offer users the ability to trade within margin accounts. Compare all of our favorite trading and investing apps here >>>