Short selling is a strategy where you aim to profit from a decline in an asset’s price. Whereas most investing involves buying an asset and selling it later at a higher price, short sellers start by selling an asset and then buy it back later, hopefully at a lower price.
What Is Short Selling?
Short selling is an advanced trading strategy that flips the conventional idea of investing on its head. Most stock market investing is known as “going long”—or buying a stock to sell it later at a higher price. If traders short a stock, they are “going short,” or betting that the stock’s price will decline.
To short a stock, a trader initiates a position by first borrowing shares from a broker before immediately selling that position in the market to other buyers.
To close out the trade, the short seller must buy the shares back—ideally at a lower price—to repay the loaned amount to the broker. If the stock’s price fell, as the trader expected, then the trader nets the price difference minus fees and interest as profit.
Selling short, as this strategy is sometimes called, is a way for traders to bet on falling prices or hedge a position. While it may sound straightforward, short selling involves plenty of risks.
If a stock’s price goes up instead of down, the short seller will lose money—and that doesn’t even include the fees to borrow shares that are part of this trading strategy.
To engage in short selling, you need to open a margin account with a broker to be eligible. Borrowing a stock—the first step in the strategy—incurs additional fees.
What Is Naked Short Selling?
Naked short selling occurs when a short seller doesn’t borrow the securities in time to deliver to the buyer within the standard three-day settlement period, per federal regulations.
According to the Securities and Exchange Commission (SEC), “Investors must settle their security transactions in two business days. This settlement cycle is known as T+2, shorthand for ‘trade date plus two days.’”
At stake in naked short selling is the trading of shares that haven’t been confirmed to exist—and can exacerbate short pressure on the stock in question. What’s more, naked short selling is typically a violation of SEC law unless a lack of market liquidity or another loophole in the market is to blame.
How Does Short Selling Work
What does it mean to short a stock? Short selling is a trading strategy to profit when a stock’s price declines. While that may sound simple enough in theory, traders should proceed with caution.
It’s difficult to correctly identify an opportunity to make a profit when asset prices are falling—and, as a result, short selling is typically a near-term strategy favored primarily by day traders.
Short selling requires traders to look at individual securities or the market differently than traditional “buy and hold” investors.
Short sellers must be comfortable adopting an inherently pessimistic—or bearish—outlook counter to the prevailing upward bias in the market. Short selling often aligns with contrarian investing because short sellers focus on strategies that are out of consensus with most market participants.
When researching possible candidates for a short sale, traders typically focus on fundamental analysis of a company’s financials to identify possible sources of weakness for the stock ahead, technical analysis of the stock’s historical trading patterns or building a case for thematic weakness that will affect a sector of stocks. Some traders will short a stock, while others will short a market as a whole via trading strategies that involve exchange-traded funds (ETFs).
Finally, some traders use short selling as a hedge to minimize losses on an existing long position in the event of falling prices. While the steps inherent to shorting the stock are the same, the goal is somewhat different. Short selling as part of a hedging strategy will help protect some gains or mitigate losses, depending on whether prices go up or down.
How to Short a Stock
While you can buy a stock with just a few simple clicks, more steps are involved when shorting a stock. And most investors can’t wake up one morning and decide to start short selling stock. Here’s a step-by-step guide for how to short a stock:
- Set up a margin account with your broker. Short selling requires the use of a margin account, which allows you to borrow money to buy securities. Before you can start trading on margin, you must meet the minimum requirements set forth by the Financial Industry Regulatory Authority, also known as FINRA. Of note, federal law typically requires short sellers to have an initial amount equal to 150% of the value of the stocks they short in the margin account, with a maintenance requirement that’s generally 30%.
- Research short-sale candidates. Once you have clearance from your broker to short a stock, you’ll need to identify an opportunity by researching stocks. And because of the potential for losses, it’s very important to come up with a sound thesis for why the stock’s price will fall in value—and one that’s based on a thorough analysis of the company and its stock.
- Make a plan for the short-sale trade. Before executing any aspect of the trade, you should set up a plan to enter into the trade—and, as importantly, exit the trade at a profit, taking into account fees and the interest charged on the amount borrowed. Since a short sale is predicated on the idea that prices will fall, you should also have a contingency plan to minimize losses should the stock’s price go up.
- Execute the short sale. Once the above steps have been accomplished, it’s time to put money behind your bet. Utilizing stop orders for trades may make it easier to execute the trade as planned without allowing emotions to factor into your decisions.
How to Short the Market
Some traders may instead focus on ways to short the stock market. While this can be accomplished by shorting an ETF that tracks a market benchmark, such as the S&P 500, there are other ways to short the stock market.
In particular, inverse ETFs do the legwork of a short sale on behalf of traders, even eliminating the need for a margin account. However, as with short selling, the risk with inverse ETFs is that the market goes up and losses magnify.
Risks of Short Selling
The most obvious risk with short selling is that the price of an asset goes up when a trader expects it to go down.
The longer you wait for a trade to become profitable, the more interest you must pay on your margin account—and the more risk you take on in the event the price continues to go up. You may also need to add more money into your margin account to avoid what’s known as a margin call—when the value of the securities in your account fall below a certain level.
A final risk with short selling is what’s known as a short squeeze. This occurs when there’s a price spike in a stock that’s been heavily short sold, which puts pressure on short sellers to close out their positions to minimize losses. In so doing, short sellers buying back the stock help spur further gains in the stock’s price.
Because of the associated risks of short selling and margin requirements, many traders may want to steer clear of this advanced trading strategy.
A less risky alternative exists in the options market—buying put options—which gives the trader the right, though not the obligation, to sell the underlying stock at a stated price later. This options strategy offers traders a way to bet on falling prices with fewer risks.