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Short selling stocks is an investment strategy that some investors can use to profit off of stocks as they decrease in value. Because of the risks involved, it's a practice that's generally best reserved for experienced investors.
It's possible to short sell stocks as a way to speculate on the price of a particular stock or to hedge against potential losses on a stock that you already own. If you're considering short selling stocks, here's what you need to know about how the process works and the risks involved.
How Does Short Selling Stocks Work?
As an investor, a profitable short sale involves borrowing stock shares from a brokerage firm, selling them, then paying back the brokerage after the price of the stock drops.
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Because the brokerage expects a certain number of shares to be paid back―not a dollar amount―you stand to gain if the price of the stock has decreased since you sold your borrowed shares. When you buy the shares to repay the brokerage, you'll pocket the cost difference. If the stock price has increased, however, you'll take the loss.
There's no set limit for how long you can keep a short position open, as long as you can maintain a certain amount of money in your account (the margin maintenance requirement) and pay the interest. If the broker continues to allow you to borrow the shares, you can take as much time as you need.
Short selling is generally used as a short-term investment strategy, but it can also be used to hedge against potential losses on a stock you own.
Examples of a Short Sale
When short selling a stock, it can go a few different ways, depending on which direction the price of the stock moves and your ultimate goal.
For example, let's say you want to short ABC Company's stock because you believe it's overvalued at $10 per share, or you have reason to believe that the stock price will decrease for some other reason. Here's how shorting that stock could go:
You borrow 50 shares of ABC Company at $10 per share and immediately sell them all for their market price, netting $500. Six months later, the price of ABC Company stock has hit $5 per share. To repay the shares you borrowed, you buy 50 shares for a total of $250 and return them to the broker. Your gain is the $250 cost difference minus any interest and other costs you paid.
In another scenario, let's say the price of ABC Company stock rises to $15 after six months. In this case, you'd have to purchase $750 worth of the company's shares in order to fulfill your obligation to the broker. This would result in a $250 loss plus interest and other costs paid.
Finally, let's say you already own 50 shares of ABC Company stock and expect it to lose value in upcoming months, but you don't want to sell your position. So, you short 50 shares of the company's stock at $10 per share. When it hits $5 per share, you have reason to believe that it will rebound, so you complete your short sale.
At this point, the value of your "long" position has decreased from $500 to $250, but if your short sale profit of $250 makes up for that loss and your only real cost is the interest and other costs paid to the broker.
What Are the Risks of a Short Sale?
Brokerage firms and investment professionals generally recommend that only experienced investors engage in short selling, and there's a good reason for that. Here are some of the potential risks you're exposed to.
Virtually Unlimited Losses
If you own $500 worth of a company's stock and the share price hits $0, the most you stand to lose is $500. However, if you short that stock and the share price increases, your potential losses are theoretically unlimited because there's no cap on how high the price of a stock can climb.
Of course, ABC Company stock isn't going to jump from $10 to infinity before you have the chance to cover your position, but there remains a much greater loss potential with short selling.
When you short sell a stock, you're essentially borrowing money, similar to using a margin account, and you're using your portfolio as collateral. When this happens, brokerage firms require you to adhere to a margin maintenance requirement. If your balance slips below that level, you'll be forced to either put more cash in the account or complete the short sale before you're ready.
In some instances, financial regulators may ban short sales temporarily on stocks across the market or in a certain sector. This may be done to mitigate investor panic. When this happens, stock prices can jump suddenly, which could force you to cover your short position with a loss.
A short squeeze occurs when the price of a stock starts to increase, and short sellers rush to buy back their positions and limit their losses. This initiates a cycle where the increased demand from short sellers pushes the stock price even higher, causing more short sellers to buy back shares and so on.
In this kind of scenario, if you're not paying close enough attention, you could end up holding onto your short position for too long, increasing your loss potential.
Costs of Short Selling
There are various costs associated with short selling that aren't concerns with traditional trading:
- Interest: Because you're borrowing shares, you'll be required to pay interest to the broker for as long as you maintain your short position.
- Other fees: Certain stocks may be more difficult to borrow because they already have a lot of interest from other short sellers or for other reasons. In these instances, you may be charged what's called a "hard-to-borrow fee." This is an annualized fee based on the value of your trade and how long you hold the short position. It can range from a fraction of a percent to upwards of 100% of that value.
- Dividends and more: If the stock you shorted pays a dividend, you're on the hook for paying that to the brokerage firm.
It's important to carefully consider all of these costs and how they might impact your ability to make profit on a short sale.
A Lower-Risk Alternative to a Short Sale
If you believe a particular stock is set to decline in value and you want to take advantage of this price movement, consider a put option instead of a short sale.
Put options give you the right, but not the obligation, to sell a stock at a specific price. For example, if you buy a put option for a $25 premium that gives you the right to sell ABC Company stock at $10 per share and the stock price drops to $5, you can exercise the option and sell 100 shares (options contracts are made in increments of 100), giving you a profit of $500 minus the $25 premium.
If the price of ABC Company stock increases, you simply don't exercise your option, and your cost is the $25 premium.
That said, options can be relatively complicated. It's crucial to make sure you fully understand what you're getting yourself into before you engage in options trading.
Consult With a Financial Professional Before Shorting Stocks
Shorting stocks can provide you with a good short-term strategy to profit off of a company's shares as they decrease in value, but the risks far outweigh the potential benefits for many investors, particularly less experienced ones.
If you're thinking about getting into short selling, consider consulting with a financial advisor first to determine if it's the right fit for you. An advisor can help by providing you with objective, personalized advice and can also help you develop both your short- and long-term investment strategies to make the most of your investment portfolio.