Short Selling Explained: How Short Selling Works

Short selling stocks is an investment strategy in which the short seller bets that a stock will decline in value. In short selling, an investor borrows stock shares that they believe will drop in price, sells those borrowed shares at market price, then buys back the shares at a lower price. To complete the short sale, the investor returns the shares to the original lender and profits the difference between the buy and sell prices. Short selling is a short-term stock trading strategy. If the stock does fall in price, investors can yield sizable profits, but they can experience unlimited losses if the price rises.

In a short sale, the short seller sells stock shares they don’t own. First, short sellers borrow stock shares from a brokerage firm. They then sell those borrowed shares at the current market price and receive the income into their account. Later, the short seller must decide to close out the short sale by purchasing back the exact number of shares sold to return the borrowed shares to the lender. Short sellers hope that the stock price drops to purchase the stock back at a lower price and profit the difference.

If the price of the stock rises and the short seller buys the shares back at a higher price, they lose money on the trade. When the price of the stock rises, short sellers may hold out in the hopes that it will decrease; since short sellers must eventually repay the broker, they risk losing more money. When the share price increases, it's possible that the broker might issue a margin call, requiring the short seller to put even more money into the brokerage account or close out the trade by repurchasing the stock at the current higher price.

There are two primary reasons that you would short sell—speculating and hedging.

1. 1. Speculating: Stock market speculators short sell by identifying what they believe is an overpriced stock so they can profit off its decline. Short selling speculation is a highly risky investment strategy.
2. 2. Hedging: Most investors who short sell stocks are hedgers. Hedgers take a short position on a stock simply to offset the risk from other long position investments. Rather than profit off a short sale, hedgers want to minimize potential losses or protect gains on other long position investments in their portfolio. Hedging is a common investment strategy for many hedge funds.

Although shorting stocks comes with the chance of netting large profits, there are several risks you should be aware of:

1. 1. Unlimited losses: Unlike a long trade, where you can only lose the money you put in, when you short trade, you can lose an unlimited amount of money if the shorted stock continues to rise indefinitely.
2. 2. Additional costs: Shorting stocks is much more costly than traditional trading. First, to borrow money from a brokerage firm, you're required to open a margin account that typically comes with a minimum margin requirement. If your brokerage account funds dip under the margin requirement, your broker will issue a margin call. In addition, when you trade stocks on margin, you must also pay interest fees that gradually add up until you return your borrowed shares. Lastly, a stock with high short interest (i.e. a stock that has a high percentage of shorted shares that haven't been closed out) might have additional hard-to-borrow (HTB) fees based on the stock's price and availability.
3. 3. Trade restrictions: Wall Street regulators like the Securities and Exchange Commission (SEC) have the authority to restrict who can short sell and when investors can short sell. They may enforce a ban on short sales to avoid panic in situations where the stock market is experiencing a furious dip in share prices, as was the case during the 2008 financial crisis.
4. 4. Potential for a short squeeze: A short squeeze is an investing phenomenon triggered by a shorted stock jumping in value. A short squeeze causes many short sellers to cut their losses by repurchasing the stock before prices increase even more. Purchasing the stock raises the shorted stock's price higher, forcing more short sellers to buy back the stock and increasing the stock's value again (this cycle continues to repeat in a loop).

All investments and investment strategies entail inherent risks and introduce the potential for financial loss or the depreciation of assets. The information presented in this article is for educational, informational, and referential purposes only. Consult a professional investment advisor before making any financial commitments.

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