What to Know About Short Selling: How It Works, Strategies, Risks, Rewards (2024)

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• Short selling means selling stocks you've borrowed, aiming to buy them back later for less money.
• Traders often look to short-selling as a means of profiting on short-term declines in shares.
• The big risk of short selling is that you guess wrong and the stock rises, causing infinite losses.

Short selling is a high-risk, high-reward trading strategy alternative to the traditional buy-and-hold investing strategies. Rather than buying a stock in the hope that it will appreciate in value, you can earn money betting against stocks.

While hedge fund managers and professional traders are the prominent players in the short-selling arena, any investor with a margin account can go short on a stock with the best online brokerages.

But are the potential benefits of short selling worth the risks? Here's everything you need to know about short selling and market manipulation.

What is short selling?

Short selling (aka shorting or taking a short position) is when investors sell borrowed stocks in the hope of buying them back for a lower price. Short selling is a high-risk, high-reward trading strategy.

When it all goes according to plan, short-selling can yield impressive returns. However, it can also lead to substantial losses, especially if a short squeeze occurs, such as the one that took place during the Gamestop trading frenzy.

To participate in short-selling, you must have a margin brokerage account with your broker. You must also meet your broker's initial and maintenance margin requirements.

How short selling works

Short-sellers usually borrow shares from brokers. Brokers will lend stocks and other assets from their own inventory, another broker's investor, or clients with margin accounts willing to lend their shares.

Margin interests must be paid on the shorted shares until they are returned to the lender. Short-sellers are also responsible for any dividends paid out while the shares are on loan, which can decrease the short-seller's overall profit or exacerbate their losses.

Regardless of how a shortened position performs, the borrowed shares must eventually be returned to the lender. If the share price decreases, the short-seller can buy them back at the lower price, return them to the lender, and pocket the difference for a nice profit. However, you'll be forced to sell the position at a loss if the price goes up.

For example, let's look at how a short sale of XYZ stock might work. Currently, the stock is being sold for $100 per share. You believe the stock's price is primed to fall and short 100 shares for a total sale price of $10,000.

Now, let's assume that your hunch was correct and the share price for XYZ dropped to $80. You buy 100 shares to replace the ones you borrowed for a total cost of $8,000. Excluding interest (and dividends if they apply), your profit would be $2,000 ($10,000 - $8,000 = $2,000).

But suppose you guessed wrong on XYZ, and the price spikes to $120 per share before you finally decide to close your position (by your replacement shares) and cut your losses. At $120 per share, you'd have to pay $12,000 to replace the 100 borrowed shares, resulting in a $2,000 loss ($10,000 - $12,000 = -$2,000).

Legal and regulatory considerations of short selling

Short sellers get a bad rap as manipulative investors who profit off other traders' misfortune, and they generally take the blame for the drop in the price of certain stocks. Despite the suspicions of some investors and policymakers, short sellers act as a crucial counterbalance to overly optimistic market valuations.

Short selling is a completely legal and regulated practice that helps stocks believed to be overvalued come down to a more reasonable price. The SEC, one of the main regulators of short-selling, keeps a close on the impact of short selling on the market and is known to limit (and even prohibit) short selling during market crises or rapid declines.

The SEC adopted an "uptick rule" (Rule 10a-1) in 1938 to prevent short selling during downticks in the market and prevent market manipulation. It also stops short sellers from artificially driving stock prices down. But this rule was eliminated in 2007 after a yearslong study by the SEC found that it wasn't effective.

In 2010, the SEC implemented an alternative uptick rule called Rule 201, which stated that a short sale could only occur if a price drop of at least 10% compared to the previous day's closing price occurred in a single day. Therefore limiting the damage caused by potential negative price spirals in a downtick market.

Advantages of short selling

Short selling, despite its risk, offers several advantages for investors, including:

• Potential for high returns: The main advantage of short selling is that it can lead to high returns by profiting on short-term declines in a stock's value. Using margin in short selling is also attractive to many traders, as it means lower capital requirements and the potential for high profit margins.
• Leverage return: Since short-selling is performed using margin, you only contribute a portion of what is needed to make the trade. This may lead to amplified returns. Remember, borrowed funds are essentially loans, so you'll be responsible for paying back the borrowed amount plus interest.
• Enforce fair value prices: Short sellers act against optimistic markets and can identify potentially overvalued assets. In return, this can enforce prices to maintain a fair value and help maintain market health.
• Increased liquidity: Short selling increases the overall volume of market trades, contributing to the overall liquidity. Increased liquidity helps encourage trade.
• Protect against potential losses: A trader may also decide to go short on stock to hedge against a long position (that is, shares they already own outright). Once the stock's value drops below a certain price, your long position loses money. However, the profits from your short sale can negate those losses.

Risks of short selling

The big risk of short selling is that you could guess wrong, and the assets you borrowed against appreciate. Unfortunately, guessing wrong on a shortened stock is much riskier than traditional investing strategies.

When you buy a stock, your upside is unlimited and the maximum amount you can lose is all of your investment (aka the stock price falls to $0). With short-selling, however, the amount you can lose is technically infinite.

Suppose you short a stock at $25 per share. if the stock were to drop to $0, your profit would be maximized at $25 profit per share. But if the trade goes against the stock, then it could rise to $50 (100% loss), $75 (200% loss), $100 (300% loss), or even higher.

Other notable risks of short selling include:

• Appreciation trend: The stock market tends to rise over the long term. So, the overall trend is against you as a short-seller.
• A short squeeze: This happens when a stock rises sharply and suddenly. Short-sellers scramble en masse to buy shares to cover their position. Each buy transaction drives the stock even higher, forcing more short-sellers to exit their positions...and the vicious cycle continues. Short squeezes typically happen when a high percentage of all the stock's outstanding shares are sold short.
• Margin dangers: Margin trading comes with significant risks of its own. First, you must pay interest on the borrowed stocks until they're returned. Second, if the shorted stock rises significantly in value, the broker could issue a margin call, requiring you to add cash or securities to your account to cover the amount you borrowed. If the margin call isn't met (typically within two to five days), the broker can sell the stock, locking in your losses.

Strategies and techniques in short selling

Short selling requires strategic planning and extensive market knowledge to identify potential stock weaknesses. Common identification techniques include analyzing charting patterns, moving averages, and the relative strength index (RSI).

You can also identify stocks by thoroughly researching a company's financials and keeping up with the news and industry trends.

Timing is another key element of a successful short selling. The best time to enter a short sale is when the identified stock or asset declines rapidly. You'll then want to exit the short sale once the downward momentum weakens.

Only experienced investors willing to conduct extensive research and make informed trades should participate in short selling. Remember that short selling is a very risky investment strategy that could become costly.

Risk management in short selling

Thoroughly researching a company's financials and keeping up-to-date with the news and economic trends is only one way to mitigate the risk of short-selling. You can also manage risk by:

• Diversifying investments: Like with any investment portfolio, diversifying your asset allocation across and within multiple market sectors is the best way to limit loss. Only a small portion of your portfolio should be dedicated to short-selling, especially because of its high volatility.
• Setting stop-loss orders: You can set a stop-loss order to lock in a certain price (aka the stock price) in case the value of the stock suddenly increases. Stop-loss orders can be used for both long and short positions.

Controversies and challenges of short selling

Short selling continues to be controversial despite regulatory rules to prevent short sellers from manipulating the market.

The main critique of short selling claims that short sellers are predatory investors who unfairly manipulate and take advantage of volatile markets to earn a profit. Short selling can compromise people's confidence in the market and may negatively impact companies and their investors.

There have been multiple attempts to ban short-selling as a legal practice, but most end up getting repealed. Temporary bands are more common as a way to help stabilize the economy, such as the one that took place during the 2008 financial crisis.

Short selling — Frequently asked questions (FAQs)

Is short selling worth it?

Short selling is a bearish or pessimistic move, requiring stock to decline for the investor to make money. It's a high-risk, short-term trading strategy that requires close monitoring of your shares and the market.

For these reasons, it may not be a suitable strategy for individual investors who prefer a passive, long-term portfolio approach.

For active traders or investors interested in market timing, short selling is a strategy that can produce positive returns even in a period of negative returns for a stock or the market as a whole. But if you decide to short stocks, ensure you fully understand the risks and have a clear exit plan for getting out of the short if the stock price rises against you.