What is Short Selling and How Does it Work?
Investing in a stock because you think its price will drop goes against the universal “buy low, sell high” maxim, but short selling is just that — an investing strategy that aims to profit from a tumbling stock price.
With short selling, investors borrow shares from a brokerage and sell them immediately, in the hopes of buying them back later a lower price. If the short is successful, the shares are purchased at that lower price, returned to the brokerage, and the investor keeps the difference in price (minus costs, of course).
Selling stock you don’t own? Borrowing from a brokerage? That’s right, short selling is a more complex process than traditional stock trading. If you’re considering short selling, also known as taking a short position in a company’s stock, it’s important to understand how it works, what it costs and the potential risks involved.
How it works
Let’s say an investor named Sarah has been researching XYZ Company for months and she believes the stock price is going to fall. Sarah decides to short 1,000 shares of the stock at its current price.
To start, Sarah’s got to take a couple more steps than just visiting her online trading platform and selecting short sell. With short selling, investors require a non-registered margin account rather than a typical investment cash account. This means Sarah must request approval for a margin account by submitting a margin agreement form.
With her new margin account approved and in place, Sarah can now get the ball rolling. Here’s how it works.
- Sarah borrows 1,000 shares of XYZ Company from her brokerage (assuming those shares are eligible and available)
- She immediately sells the shares at the current price, say $10 a share, and the $10,000 (minus costs) received from the sale is placed in her margin account as collateral for the borrowed shares. She knows she may have to add funds to her margin account to cover market fluctuations (see Mark to Market below.) Find out more in Understanding Margin Accounts.
- Sarah waits
At this point, there are three possible outcomes. The stock price could rise, fall or stay roughly the same. Eventually, no matter what the scenario, Sarah must buy back the shares in the market in order to return them to her brokerage.
Let’s take a closer look at the three possible outcomes:
Stock Price Rises. This would be the worst-case scenario. Sarah sold the borrowed shares at $10 a share, but let’s say the stock price has now climbed to $13 a share. In order to buy back the shares to return to her brokerage, she would would have to pay $13,000 plus costs, or $3 a share more than when she borrowed them. This wouldn’t be considered a successful short. On top of this, Sarah may face a margin call, which means she’d be required to deposit additional funds to her margin account to cover any shortfall.
Risk alert! The potential for loss in short selling is limitless, but potential gains are limited. When you buy stock, no matter what price you pay per share, your investment can only fall to zero. But when you short stock, you lose as the stock price rises. Because a stock’s price can, in theory, rise indefinitely, there’s potential to lose much more than your initial investment.
The reverse is true of potential gains. When you buy stock, the price can, in theory, rise indefinitely. But when you short a stock, you gain as the price falls. Because a stock’s price can only fall to zero, your gains are limited to the difference between the original price of your short and zero.
Stock Price Stays the Same. With this case, Sarah will have to decide if she wants to continue to short the stock or close the position with minimal cost. Interest and dividend payments continue to accrue as long as she shorts the stock (see more in What Are the Costs below), so Sarah would only continue to short the stock if she believes there is still potential for its price to fall.
Stock Price Falls. This is the best-case scenario. Sarah sold her borrowed shares at $10 each, but the stock price is now $7 a share. She can buy back the shares, return them to her broker and keep the difference — in this case $3 a share, or $3,000, minus interest, fees and any dividend payments. This would be a successful short. (If she thinks the stock price will continue to fall, she also has the option to wait.)
What Are the Costs?
As with any stock transaction, there are administrative and other costs to consider beyond the price of the shares. With short selling, the following costs may apply:
- Trading fees. You are buying and selling stock, so standard brokerage commissions apply. Find out more in Understanding Commissions & Fees.
- Dividends1. If the stock you’ve shorted pays a dividend during the time you hold the short position, you are responsible for paying that dividend amount to the brokerage you borrowed the shares from.
- Mark to Market. Remember, with short selling you want the price to fall. So, if it rises instead, it can cost you. Mark to market means cash would be deducted on a weekly basis from your margin account to cover the increase. (Of course if the underlying securities drop in value, funds would be credited to your account instead.) It’s up to short sellers to maintain adequate margin to account for stock-price fluctuations.
- Other considerations. There can sometimes be instances when a short seller could be asked to cover their position immediately, depending on the availability of the underlying security. That means shares would need to be repurchased at current market prices in order to return the borrowed ones.