If you know anything about trading, you may have come across the saying ‘Buy Low, Sell High’. Short-selling is the antithesis of this approach, with short-sellers aiming to ‘Sell High, Buy Low’ and profit from a price drop. Shorting a stock isn’t for the faint-hearted; it’s a high risk/reward trading strategy with the potential for uncapped losses if you get it wrong.
In this guide, you will learn:
Short selling stocks is the process by which an investor borrows a stock and then sells it with the goal of buying it back at a lower price in future, hence making a profit. The short seller has to return the shares back to the lender after buying them back. Short selling is typically regarded as an advanced trading/investing strategy that is not suitable for beginner traders.
Short selling is a risky strategy because the investor losses money whenever the price of the stock they are shorting goes up. Historically, stock prices usually tend to rise over time and could keep rising to infinity exposing the investor to unlimited losses. However, the reward for short-selling is fixed because the stock can only fall back to zero.
Short selling involves borrowing a stock from someone who owns it, which in most cases is your broker, and then selling it to another person. This process is known as ‘selling to open’ because you are opening a new position by selling the stock instead of buying it. Your broker will require you to set aside some funds to back your position, which is known as margin.
Therefore, you need a margin account in order to short stocks given the risks associated with the strategy. Once you have sold the borrowed shares, you will receive a credit in your account equal to the price paid by the buyer. You only make money on the trade if the stock’s price keeps falling, and you lose money as the stock’s price rises.
You do not have to worry about finding someone whose shares you can borrow as this part is handled by the broker. The broker could even buy the shares and lend them out to you for your short trade so long as you have sufficient margin in your account.
The main advantage associated with short selling is that a trader can use this strategy to protect their portfolio from future losses. For example, an investor who owns stock in XYZ company and is sitting on decent profits accrued over say several months may feel that the stock is likely to sell off after an upcoming earnings report. The investor could initiate a short trade to profit from the potential decline without selling their current holdings.
If the trader uses margin to fund the trade, which most short-sellers do, then they stand to make a significant profit given that they did not use any of their own money. Traders who own the shares they are shorting stand to minimise their losses by booking an extra profit from the price decline, instead of watching as their open profits evaporate.
The main disadvantage associated with short selling is that the potential gains from this strategy are limited, while the potential losses are unlimited. This goes against the basic principles of successful investing and trading, which are built around minimising risks while expanding one’s profit potential. We discuss a real example of short selling going wrong further within the article.
Another major drawback of short selling is that it could tie up your investment capital for years before bearing fruit as evidenced by the biggest short selling trades in history. For example, hedge fund managers who shorted the housing market made huge profits when the subprime mortgage crisis hit in 2008, but had sustained significant losses initially.
When short selling, you have to pay interest on the margin provided by the broker, since you’ve effectively loaned the shares. You could also be subject to margin calls if the stock’s price rises above the margin requirement for the position, which is usually 25%. Therefore, if the stock rallies and your margin falls below 25%, you will have to add funds to your account to reach the required limit or be forced to liquidate your position.
A short squeeze usually occurs when stock prices start rising forcing short sellers to buy back their shares in order to cover their positions. The buying frenzy causes the stock’s price to keep rising, hence, attracting more buyers and forcing more short sellers to cover their positions. This usually becomes a self-fulfilling loop that could last for a while causing short sellers to incur massive losses over a short period.
Generally, stocks tend to go up over time as evidenced by the fact that the S&P 500, the FTSE 100 and most stock indices trade at higher prices today than they did say five years ago. Only on rare occasions when we get a recession and a bear market do most stocks head lower. Therefore, most short-sellers are usually going against the trend when shorting a stock, which increases the chances that they could be proven wrong.
Given that short sellers are usually betting against the trend, it is not surprising that most times their bets work against them because they are too early. Most short trades take time to work out because of this fact and given the interest payments and margin requirements, it is expensive to hold short trades for long periods.
Regulators may also decide to halt the shorting of particular stocks if their prices fall beyond a certain threshold over a short period such as a trading session. This could force the stock’s price to rise due to the low supply conditions created by the short-selling ban.
Investors can also simulate shorting a stock by using Put and Call options to create a synthetic short position. A Put option gives its holder the right, but not the obligation, to sell the underlying security at the specified price within the specified period of time.
A Call option gives its holder the right, but not the obligation, to buy the underlying security at the specified price within the specified period of time. Naturally, the prices of options contracts are directly impacted by the price of the underlying security.
If shorting a stock with options, an investor would usually buy a Put option or. By doing so, the Put option will increase in value if the price of the stock falls. However, simulating a short position using options carries certain limitations since options have expiration dates.
Once an option expires, the investor has to either meet the obligations of the options contract or close out his position. Those time limits don’t exist when shorting a stock the traditional way.
There are many disadvantages associated with short selling chief among them being the fact that a stock’s price could rise to infinity while it could only fall back to zero. A good case of short selling gone wrong is Tesla’s rally in 2020 as illustrated in the chart below.
You can see that Tesla rallied from $421 at the start of the year marked by the black line, to a high of $1,505 at the time of writing. People who were short Tesla stock at the start of the year have lost about $1,100 per share, yet their max gain was just $421. This is exactly what we mean when we say that a company’s share price can rise to infinity, but it can only fall to zero.
The short-sellers stand to lose way more if Tesla’s stock rallies higher, which we can never rule out given that companies such as Berkshire Hathaway trade above $280,000. Simply put, Tesla’s future gains are unlimited, whereas its losses are limited to its current share price. Hence, a short seller’s gains are limited, while his losses are potentially unlimited.
Short selling only makes sense in rare situations where the odds of a company’s stock price falling are high such as when it is in huge financial troubles, or when the investor has discovered major flaws with a firm’s business model such as illegal business practices. However, it may take a long time for the market to realise the same triggering a fall in the stock’s price.
The best time to short a stock is near its highs when the price is highly overextended and there is a negative trigger. You should have studied the stock for a while before shorting it to identify when it is overvalued and there is likely to be a negative trigger such as a missed debt payment. Shorting the stock ahead of a negative trigger increases the chances of the trade working in your favour.
The first step to shorting a stock in the UK is to open an account with a broker who offers stock trading. You can choose from some of the top brokers we have reviewed and verified. You should make sure that you qualify for a margin account so that you can short stocks.
The next step is to find a stock to sell short using the criteria outlined above where it is trading near major highs and you expect a negative event to trigger a selloff.
Always manage your risk by having a predefined stop-loss order, which in this case is a price at which you will buy back the stock if it keeps rising.
You are now ready to start shorting stocks.
Remember that short selling is an advanced trading strategy that is not suitable for beginner or retail investors. You have a better chance of becoming a consistently profitable trader by trading with the trend using long positions instead of fighting the trend by shorting stocks.
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