When most people think about trading stocks, they’re thinking of how to bet on a stock.
That’s simple enough – if you think a stock is going to do well, buy some while the prices are relatively low and then sell when you think it’s not going to get any higher (or keep them long term for the dividends).
Betting against a stock, often called short selling (or just shorting) is a bit more complicated, but if you play your cards right then it’s a great way of earning money from a stock you think is on the way down.
In this article, we’ll explain exactly how short selling works and how you can make money from it.
What Is Short Selling?
Simply put, short selling is when you bet against a stock.
More formally, it’s a particular investment strategy in which you judge that a stock is going to decline in value and then take advantage of that to profit.
It works like this: the investor (you) borrows shares from a brokerage firm that they think will drop in price. They then sell those shares at their market price (let’s say this is $10).
The shares then drop in price (let’s say to $5). The investor then completes the sale by buying back the stocks at the new, lower price to give back to the lender.
They then have the difference between the original, higher price and the new, lower price, as profit.
It might help to think of it in more everyday terms. Imagine that you borrow your friend’s car for the day. You then sell the car for $5000 that morning.
If you can buy the car back for less than $5000 before the end of the day and return it to your friend, you’ll have made a profit. That’s essentially what short selling is.
Of course, if the price of the car rises above $5000, you’ll either be out of pocket or have a very angry friend – those are essentially the risks of short selling, too.
Why Engage In Short Selling?
There are generally two reasons an investor might want to engage in short selling. These are:
1. Speculating
Speculators attempt to profit from short-selling by identifying a stock that they believe is overvalued, hoping to profit from its expected decline.
This can be profitable, but is highly risky, as you’ll see in the next section.
2. Hedging
The most common and less risky way of short selling. Hedgers don’t short sell specifically to make a profit, but rather to balance the risk they’re exposed to on their other, longer-term investments.
This strategy is particularly common among hedge funds.
What Risks Come With Short Selling?
Short selling is a lot riskier than the traditional method of buying stocks that you think will rise in price. If you’ve been thinking ahead, then you’ve probably already worked out why this is.
Usually, if you buy a stock, the absolute worst that can happen is that you lose 100% of your initial investment (i.e., if the value of your stocks drops to $0 and stays there).
However, if you’re short selling, it can get worse than that. While it’s impossible for a stock’s value to drop below zero, there is no specific limit on how high a stock’s price can rise.
Imagine that, as in the earlier example, you borrow stocks to short sell them for $10 each. If the stock price rises instead of falling, it could reach $20, $30, $40, or more per share.
This will cost you not only your initial investment but also the difference between that price and the new price.
Since you only borrowed these stocks, you have to return them to the lender and that means having no choice but to pay the new price, no matter how high it is.
It is sometimes possible for the investor to hold out and hope for the price to fall again, but not always.
If the price rises, the brokerage firm that lent the stocks to the investor might issue something called a margin call.
This means that the investor must either return the shares immediately (obliging them to pay whatever the current market price is) or place more money into the brokerage account.
Either way, they’ll be out of pocket.
To be absolutely clear about this, the potential losses are unlimited when it comes to short selling, so make sure you really know what you’re doing before you decide to try it.
Restrictions On Short Selling
Although short selling is generally allowed with no special limitations, regulatory authorities are empowered to restrict short selling.
They are particularly likely to do this at times when stock prices are falling quickly to prevent a stock market panic.
These restrictions can be put into place quite quickly, so if you’re short selling and not paying close attention, you might be caught out if limitations are put in place unexpectedly.
What Is A Short Squeeze?
A short squeeze is a situation where a stock that is being shorted increases in value quickly.
In this situation, it’s common for short sellers to try to minimize their losses by buying back the stocks before the price rises even higher.
This can cause the price to rise further, causing more short sellers to cut their losses, which forces the prices higher still. This loop can then continue.
Final Thoughts
That, in a nutshell, is short selling, or, if you prefer, betting against a stock.
It’s certainly true that lots of money can be made by short selling, but it’s vital that you’re fully aware of the risks before you engage in it.
With unlimited losses possible, you don’t just stand to lose your investment but a whole lot more if things don’t go as you expected.
For more information, it’d be a good idea for you to consult with a financial advisor before you commit to any kind of financial investment.
