How To Short A Stock: Risks & Examples (2024)

What Is Short Selling?

Short selling, or to "sell short," means that an investor, or short seller, borrows shares/units of an investment security, usually from a broker, and sells the borrowed security, expecting that the share price will fall. If the share price does fall, the investor buys those same shares/units back at a lower price and can make a profit. The short seller then returns the borrowed security to the lender.

Warning: Shorting is not for the faint of heart, and can expose investors to unlimited losses. Markets are unpredictable and short sellers can end up losing money if the security price goes up instead of down as they expected.

How To Short a Stock: 4 Basic Steps

The investor will target a particular stock that they believe will decline in value. The shares are usually borrowed from a broker, who then locates another investor who owns the shares, and borrows them, promising to return the shares at a pre-arranged later date.

The investor immediately sells the shares they borrowed at the prevailing market price and holds the cash generated from the sale.

Hoping that the borrowed shares they sold declines in price, the investor then buys the shares back.

The investor returns the borrowed shares of stock to the lending broker. If the stock is lower in price, the investor profits by pocketing the difference between the price of the borrowed shares that were sold and the price at which the returned shares that were bought back, net of any fees paid to the broker.

Tip: To borrow shares of stock, an investor will need to open what's called a margin account with their broker. The privilege of borrowing shares on margin generally involves a fee that is paid to the broker.

Risks of Shorting a Stock

Short-selling is primarily a short-term investment strategy designed for stocks or other investment securities expected to decline in price. The main risk associated with shorting a stock is that the shares will increase in price. Other risks of shorting a stock include margin calls and forced short covering.

The risks of shorting a stock are:

• The shorted stock rises in price: When investors short a stock, they can profit if the share price falls but will lose money if the price rises. This risk is potentially unlimited because in theory there is no upper limit to the share price of a stock.
• Margin call: The lending broker can invoke a margin call, which forces the investor to deposit additional funds or close the short position by buying back the shares. If the stock price rises, the short seller will take on losses. Losses could trigger a margin call.
• Short covering: If the shareholder who lends the stock to the short seller wants their shares back, the broker who facilitated the short sale could force the short seller to cover their short. This could cause an unexpected loss to the short seller.

Warning: The more a stock price rises, the more losses a short seller takes on. There is no upper limit on the price of a stock. Since short selling theoretically creates unlimited risk to the investor, selling a stock short is not recommended for beginning traders.

Requirements to Short a Stock

Shorting stock requires a margin account because short selling involves selling stock that is borrowed and not owned. Because of this, margin accounts have strict requirements, such as the "initial margin requirement," which is a minimum amount of money that needs to be in the account at the time of the trade.

Margin Requirements for Trading Stock

Before trading in a margin account, the investor must be approved for margin, which is subject to the rules of regulatory bodies, such as the Federal Reserve Board and the Financial Industry Regulatory Authority (FINRA), and securities exchanges, such as the NYSE and Nasdaq. A brokerage firm's margin requirements may be more strict than those of the regulators.

• Initial margin requirement: For short sales, the Federal Reserve Board's Regulation T requirement is 150% of the amount of the short sale at the time sale is initiated. So, if an investor wanted to initiate a short sale worth a total of $10,000, they'd be required to have $15,000 in the short sale account.
• House margin requirement: House FINRA Rule 4210 requires that investors maintain at least 25% equity in the margin account at all times. Some brokerage firms have house margin requirements that are more strict, requiring higher equity balances.

Cost of Borrowing a Stock

The cost of borrowing a stock to short can vary but typically ranges from 0.3% to 3% per year. The fees are applied daily. The borrowing fee can be much higher than 3%, and can even exceed 100% in extraordinary cases, as it is influenced by multiple factors. For example, similar to loan costs, the lender charges a leasing rate. This leasing rate for margin varies by the broker but is typically driven by whether or not a stock is "easy to borrow" or "hard to borrow."

If there's a great demand to borrow a stock, the borrowing rate for Shorting will often be higher than if there was little interest in borrowing the stock. The laws of demand and supply apply to the cost of short selling as well.

Examples of Shorting a Stock

A good way to learn about short selling is to consider a few examples - one where the stock seller makes a profit, and another where the short seller experiences a loss.

Example Where A Short Seller Profits

Let's say shares of XYZ Company stock are trading for $80 a share. An investor, who thinks that the price is way too high, contacts their broker to sell the stock short and the broker finds 100 shares from another investor. The broker lends the shares to the short selling investor. The short seller sells the borrowed shares and keeps the $8,000 proceeds from the sale.

Two weeks later, the company reports extremely poor quarterly earnings and the stock falls to $70 a share. The short seller buys 100 shares of XYZ Company stock for $7,000, gives the shares back to the brokerage they borrowed them from and makes a $1,000 profit.

Example Where Short Seller Loses

Now imagine the same scenario, where a short seller borrows 100 shares of XYZ stock and immediately sells them at the prevailing $80 share price. But in this scenario, instead of the extremely poor earnings the short seller expected, XYZ Company has surprisingly strong earnings and the stock jumps up to $90 per share. Worried that the stock price will continue to rise, the short seller exits the position at $90 per share and buys them back for $9,000, which creates a $1,000 loss for the short seller.

Synthetic Short Stock Alternative

A synthetic short stock alternative is an options strategy where an investor buys a put option and sells a call option at an equal or nearly equal strike price. Following this strategy, the investor profits if the stock price falls. Because the investor's goal and the risk/reward profile is similar to that of shorting a stock, this strategy gets the name, "synthetic short stock".

Bottom Line

Short selling is legal and is relatively easy to set up with a broker. While selling a stock short can be profitable, short selling theoretically creates unlimited risk to the investor.