What Is Short Selling? The Benefits and Risks Explained

ByG. Dautovic
March 21, 2022

When the stock market is doing well, it can be a great time for an investor to make some potentially profitable trades. You can buy stocks and trade them rapidly, or you can hold them for years, watching your portfolio grow as the value of the stocks increases.

But what should you do when the stock market takes a turn for the worse? One option is to short sell a stock. In this article, we’ll answer the question “what is short selling?” We’ll explain how it works, what its benefits are, and how risky it can be.

The Basics of Short Selling

Short selling is an investment strategy that is used when an investor believes that a stock will go down in value.

To short sell a stock, the investor borrows shares of the stock from another party, sells the borrowed shares at the current market price, and hopes to repurchase the shares at a lower price so they can return the shares to the lender and pocket the difference.

This way, the investor can make money even when the stock markets are going down.

How Does Short Selling Work?

For example, let’s say you think that a company (we’ll call it ABC - no relation to the broadcaster!) is overvalued and due for a price correction. You could borrow 100 shares of ABC from your broker and sell them immediately. Let’s say the current market price for ABC is $50 per share.

You would receive $5,000 for that sale ($50 x 100 shares). Now, let’s say that over the next few weeks, the price of ABC stock falls to $40 per share. You could buy 100 shares of ABC for $4,000 and return the shares to your broker.

Since you sold the shares for $5000 and bought them back for $4,000, you would have made a profit of $1,000.

Now that you’ve made a profit, you can use that money to reinvest in other stocks that you believe will go up in value. This way, you can continue to make money even when the market isn't doing well.

What Are the Benefits of Short Selling?

There are many benefits to this type of investing. First of all, it allows you to make money when the market is going down. This can be a great way to protect your portfolio from losses. Second, it gives you the opportunity to buy stocks at a lower price.

When the market crashes, there are often some great deals to be had. Third, it allows you to hedge your bets. If you’re already long on a stock, you can simultaneously short the same stock to offset any potential losses. 

Finally, short selling can be a great way to diversify your portfolio. By shorting stocks, you can add another layer of protection to your investments. This helps reduce your overall risk and can lead to higher returns in the long run.

How to Short a Stock

If you're interested in shorting a stock, there are a few things you need to do. First, you need to find a broker that offers this type of investment. Not all brokers offer the ability to short stocks, so be sure to check with yours first. 

Once you’ve found a broker, the next step is to research the stock you want to short. This is important because you need to have a good reason for believing that the stock’s price will decrease. Once you’ve found a stock that you think is a good candidate for shorting, you need to place your order with your broker. 

Another thing you should consider when developing your short selling strategy is setting a stop-loss order. A stop-loss order is an order to buy the stock back if it reaches a certain price. This is important because it helps limit your losses if the stock price starts to go up instead of down. 

Next, you need to wait for the stock price to start falling. Once it does, you can start selling your shares and making a profit. Just be sure to keep an eye on the stock price and make sure it doesn't rebound too much. 

If you're looking for a high-risk, high-reward investment, short selling may be right for you. Just be sure to do your research and understand the risks involved before you start trading. 

Short Selling Risks

While there are many potential benefits, there are also some risks of short selling that you should be aware of. If the stock price goes up instead of down, you could end up losing your money. If this happens, you’ll have to buy back the shares at a higher price and return them to the lender.

Such a situation will cause a loss of capital, and potentially a big one, as the hedge funds that short sold GameStop in 2021 discovered.

Another risk is that you may have to pay interest on the shares that you borrow. This can eat into your profits or even lead to a loss. Also, there’s always the risk of a short squeeze. This happens when the price of a stock starts to increase, and people who are short start to buy back the shares to cover their positions.

This can drive the prices up even further, leading to even more losses. A similar thing happened with GameStop, although in that case it was small-time investors banding together to push the stock’s price up and take down the fat cats.

As you can see, there are both risks and rewards to this type of investing. Understanding short selling can help you make more informed decisions about when to enter and exit the market. However, it’s important to remember that all investments come with an element of risk, and short selling is about as risky as it gets.

Therefore, you should collect as much information as you can and consult a financial advisor to get the most accurate advice.

Short Selling Alternatives

If you're looking for a way to make money on the stock market but don't want to take on the risks of short selling, there are other options available. Now that you know how short selling works, you can explore other investment strategies that may be a better fit for you.

For example, you could invest in bonds or stocks that pay dividends. Dividend-paying stocks tend to be more stable and offer a steady income stream. Another option is to invest in mutual funds or exchange-traded funds (ETFs). These types of investments offer diversification and can help reduce your overall risk.

Before you start investing, it's essential to understand the different types of risks involved. Short selling is one way to make money in the stock market, but it's not for everyone. Be sure to do your research and understand all the potential risks and rewards before you start investing.

Short Selling vs. Regular Investing

We’ve already mentioned that there are many different investment strategies that you can pursue. You’ve already had short selling explained; now let’s see how short selling compares to regular investing. 

Traditional investing involves buying stocks in the hope that the price will go up so you can sell them at a profit. With short selling, you’re hoping that the stock’s price will go down. However, you’re also borrowing the shares from someone else, meaning you’ll have to return them at some point. 

Another difference is that with regular investing, you can hold on to the stock for as long as you want. With short selling, there’s a time limit. This is because you’re borrowing the shares from someone else, and they will need them back eventually.  

Lastly, short selling is a more complex investment strategy than traditional trading, which means it can be much riskier. This is because you’re betting that the stock price will go down. If the stock price goes up instead, you could lose not just a lot, but technically an unlimited amount of money. 

What Is Naked Short Selling?

Naked short selling is when a trader sells a security they don’t own and haven’t borrowed. This is different from regular short selling, where the trader first borrows the security before selling it. 

Naked short selling is illegal in many countries, as it can be used to manipulate the market. For example, if there is a lot of naked short selling of a stock, it can drive the price down. This can lead to other investors panicking and selling their shares as well, which can create a snowball effect and cause stock prices to crash. 

Short Selling Terms You Should Know Before Investing

You now know the definition of short selling and the way it works. The only thing left to do is go through some terms that are specific to this type of investing. This will help you understand the process better and make more informed decisions. 

  • Short Position

A short position is when you sell securities you do not own. You hope to buy the security back at a lower price so you can make a profit. However, it's vital to know that you can be forced to buy back the security at a higher price if the market moves against you. 

  • Short Covering

Short covering is when you buy a security to close out a short position. This is usually done when the price of the security has increased and you want to limit your losses. The short covering process is the opposite of short selling. With covered short selling, you would first borrow the security, sell it, then buy it back at a lower price. 

  • Short Interest

Short interest is the number of shares that have been sold but not yet repurchased. It is used to gauge investor sentiment, as it shows how many people are betting that the stock price will go down. If the short interest ratio is high, it means that there are a lot of people betting that the stock’s price will go down. 

  • Short Squeeze

A short squeeze is when the price of a security goes up sharply, causing short sellers to buy back the shares they sold. This can create a snowball effect and cause the stock price to rise even higher. Selling a stock short is a risky investment, and you should be aware of all the risks before you decide to start the process.

  • Margin Account

This is a kind of brokerage account that enables you to borrow and then invest funds from a broker. This can be useful if you want to buy more shares than you have money for. However, it also increases your risk, as you’ll have to pay back the loan plus interest. 

  • Margin Call

A margin call is when your broker asks you to deposit more money into your account because the value of your shares has fallen. This is done to protect the broker from losses. 

Final Thoughts 

Selling stocks short is an intriguing investment strategy that can be extremely risky. However, it can also be very profitable if done correctly. Make sure you understand all the potential risks and rewards before you start investing. This will help you make smarter decisions and avoid making any costly mistakes.

Once your journey starts, remember to keep your emotions in check and always make sure you have a plan. If all goes well, you could make a pretty penny!

FAQ

Is short selling legal?

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Yes, short selling is legal. However, there are some restrictions in place. For example, you may not be able to short a stock that has been designated as a "restricted security." These are usually stocks of companies that are in financial trouble. What's also important to note when selling short is that you can only short a stock that you have permission to borrow.

What are the rules for shorting a stock?

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The Securities and Exchange Commission (SEC) has put in place rules to limit the amount of shorting that can be performed on a stock. These are known as the "uptick rule" and the "tick test." The uptick rule states that you can only short a stock if the last trade was at a higher price than the previous trade. The tick test states that you can only short a stock if the last trade was at a price that was higher than the bid price.

How much does it cost to short a stock?

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Now that you know the answer to "What is short selling?", you may be wondering how much it costs to actually do it. The cost will, of course, depend on the stock you buy and the broker you use. Some brokers will charge a commission, while others will charge a fee based on the number of shares you borrow. When choosing a broker, it's important to compare their fees to see which one is the most cost-effective.

About author

I have always thought of myself as a writer, but I began my career as a data operator with a large fintech firm. This position proved invaluable for learning how banks and other financial institutions operate. Daily correspondence with banking experts gave me insight into the systems and policies that power the economy. When I got the chance to translate my experience into words, I gladly joined the smart, enthusiastic Fortunly team.

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