Joy Wallet is advertiser-supported: we may earn compensation from the products and offers mentioned in this article. However, any expressed opinions are our own and aren't influenced by compensation. To read our full disclosure, click here.
Most of us invest in stocks with the aim to sell them at a higher price. We anticipate a price rise and hold until the stock reaches there. But short selling is the exact opposite of the traditional long position. In this case, you make money when the stock price drops.
Short selling is a short-term investment process where you anticipate a dip in the price of a stock and the difference between the buy price and sell price is your profit. It might seem like a straightforward concept but it is an advanced trading strategy ideal for professional traders. Besides the opportunity of making big profits, there is also the risk of things going wrong and losing all the investment.
There are two sides to consider: If the stock price falls as expected by you, it is possible to make 100% profit since the price will not fall below zero dollars. However, if the stock prices start to rise, there is no ceiling price and it could lead to unlimited losses.
Jump To
How does short-selling work?
Short selling works differently than traditional stock trading. When you want to short sell a stock, you will have to borrow the shares from the brokers and then sell them with the hope that the price will fall soon. Once the price falls, you can repurchase the shares at a lower price and return them to the brokerage. This will leave you with a profit which is the difference between the sale and purchase of the stock. Remember that you have borrowed the shares and you do not own them so you need to return them to the brokerage.
Let us take an example here. You borrow 20 shares of a company and sell them for $20 each, generating $400. If the share price falls to $10, you can use the $400 to buy back the shares for only $200 and the balance of $200 will be your profit.
To short a stock, it is important to have a margin account at a brokerage. You can only borrow a stock to short sell through the brokerage. It is a loan by the brokerage and is known as a margin loan. This means you will be paying interest on it and the borrowed shares are the collateral you have to put up.
When you sell the shares, you are selling them in the market with the hope that the price will decline. Once that happens, you can buy back the shares, return them to the brokerage and take home your profit. Besides stocks, you can also short exchange-traded funds.
Reasons To Use Stash For Investing
- Get $5 to Make Your First Investment
- Invest in Stocks and ETFs with $1 or Less
- Receive Your Paycheck up to 2 Days Faster
- No Overdraft Fees or Minimum Balances
How to borrow stock to short sell
Borrowing shares is the first and the most basic aspect of shorting. But there is a lot that goes into the process. Let us look at it in detail.
Getting started
Since you want to borrow shares from the brokerage, you will have to open a margin account with the brokerage to hold the stocks, bonds, mutual funds, or cash as collateral. A standard brokerage account will not work here because only a margin account allows you to borrow funds or stocks. You may have to meet the margin minimum maintenance requirements of the online broker.
It could differ from position to position but it usually requires you to have 25% to 35% of the total value of the position in equity. Hence, if you own $5,000 worth of stock, you will have to maintain at least $1,250 in your portfolio at all times. Whenever the portfolio goes below the margin requirements level, the brokerage will issue a margin call and you will have to pay back the cash you had borrowed.
You will pay interest on the value of outstanding shares until you return them. After opening and funding the account, you should start research on the best short-sale stocks. Experienced traders use fundamental analysis and technical analysis to identify the short-sale target. You can also use screening tools to identify the stocks that fit your criteria. Here are a few signs to watch out for:
- A rise in stock price when the rest of the market is flat.
- The stock is trading over its average 52-week high.
- Sudden rise in the trading volume.
- There is a quick price rise which cannot be explained by any news or the changes to the financial position of the company.
Entering the trade
Similar to any other trade, it is important to identify the entry and exit point and the stop order before you start. A stop order can help limit the losses if the trade moves against you. There are two types of stop orders. One is the buy-stop order which will trigger the order to buy back shares if the stock prices rise over the stop price. Another option is trailing buy-stops where you specify a stop price which is the lowest price of the stock in terms of a dollar amount or the percentage. When the stock goes above this price, it will trigger a buy market order and if it drops, the stock will reset at a lower price. Remember, there is no guarantee that the order will be executed at the price you designate. Now decide on the number of shares you want to short and place the order.
Set the exit strategy
Do not make the mistake of making a short position without having any exit strategy. When you do not follow the buy and hold strategy, you must know when and how you will get out of the position. To place a short position, you must identify the price at which you will buy shares in order to cover the position. Hence, set the exit price or put a buy-stop on the order. Remember to follow the stock news so that you are ready to exit when you need to.
Open and cover the short position
Once you identify the stock and decide on your exit strategy, you are ready to open the short position. This is when you borrow them from the broker and sell them at the current rate. Now you need to cover the position, which means buying back the same shares you borrowed. After you buy them, the broker will take the shares and charge the fees or commission. The balance is your profit.
Costs of Borrowing
There is a cost associated with borrowing a stock to short sell and it can vary from 0.3% to 3% annually. This fee will be applied on a daily basis and the borrowing fee can also be higher than 3%. The lender will charge a leasing rate and the margin for it will vary by the broker but it is usually driven by whether the stock is hard to borrow or easy to borrow. When there is a high demand for the stock, the borrowing rate will be higher than if there was little demand. Let us take a look at the costs in detail to minimize the potential loss.
- Margin interest cost: Short selling is only possible in a margin account and you need to pay interest on the funds you borrow. This is the margin interest cost.
- Cost of borrowing: Some stocks may be difficult to borrow due to the high short interest and in order to borrow them, you need to pay a hard-to-borrow fee which is based on the annualized rate. It could be high based on the number of trades that it is open for.
- Dividends: You have to make the dividend payments on the stock as well as other payments including the stock split. This amount could be significantly high.
Reasons To Use Stash For Investing
- Get $5 to Make Your First Investment
- Invest in Stocks and ETFs with $1 or Less
- Receive Your Paycheck up to 2 Days Faster
- No Overdraft Fees or Minimum Balances
Things to keep in mind when borrowing stock to short sell
Besides the risk of losing all your money from the stock price rising, there are many other things you need to keep in mind when borrowing stock to short sell.
It uses borrowed money
Also known as margin trading, shorting will require you to open a margin account and borrow money. This means you will have to use the investment as collateral. You must also meet the minimum maintenance requirement and when the account falls before it, you will be subject to a margin call and be asked to put in more cash or liquidate the position.
Short Squeeze
When a stock is heavily shorted, it has a high short float and a risk of a short squeeze. This will happen when the stock starts to rise and short sellers try to reduce the losses by covering their trade and buying back the short positions. Once this starts, it will get into a loop and as the demand for the stock rises, it will attract more buyers and push the stock further higher, causing either loss to short-sellers or requiring them to buy back to cover the position.
Timing
When you buy stock to short sell, you need to remember that it will not start to decline immediately. It will take a while and in the meantime, you will be paying interest and could be vulnerable to the margin calls.
Related: Motley Fool Review
Use Motley Fool's Stock Advisor To Invest
- Over 100 Stock Picks with 100%+ Returns
- Averaged Stock Pick Return over 593% (vs. 165% for the S&P)
- 2 New Stock Picks Every Month
- Investment Community With 700,000+ Loyal Members
- 30-Day Membership-Fee-Back Guarantee
- Joy Wallet Reader Deal: The Motley Fool is offering 50% off its top stock-picking service for new members (Limited Time)
Other risks
It is possible that the regulators impose bans on short sales in a certain sector so as to avoid panic and selling pressure. This move could push the stock prices higher and force the short seller to cover the position at massive losses.
FAQs
How long is it possible to short a stock?
You can short the stock as long as you feel like but since it involves borrowing the stock from a broker, the broker will charge fees until you settle the debt.
What about the dividends that are paid on the borrowed stock?
Since you are borrowing the shares of the stock, the dividends will be due to the lender. You will have to pay the dividend to the lender.
Can you lose more than you have invested?
It is possible to lose more than you have invested in the stock and the losses in short selling can be infinite. In contrast, when you follow the traditional long strategy, the most you lose is the amount you have spent on the purchase of the stock but in a short sell, you lose more than that. The stock of a price can continue to rise and there is no limit to it, as the stock soars, your losses pile up. This is something short sellers need to be careful about.
Will shorting of the stock bring its price down?
It is not likely that you can impact the price of a stock with a single short sale order. But heavy selling can put downward pressure on the stock prices and if enough people sell the stock at the same time, it can drag down the price.
Reasons To Use Stash For Investing
- Get $5 to Make Your First Investment
- Invest in Stocks and ETFs with $1 or Less
- Receive Your Paycheck up to 2 Days Faster
- No Overdraft Fees or Minimum Balances
The bottom line
Investors need to keep in mind that stocks generally have an upward drift and in the long term, the price of the stock will appreciate. Even if the company does not report solid fundamentals or barely improves in performance, the rate of price increase in the economy will drive the stock upward to some extent and this means shorting is similar to going against the direction of the market. The volatility in the market will have an impact on the market price of the shares and shorting is a strategy that should be carefully followed.
Short selling is not suitable for everyone. It requires a lot of knowledge and trading skills to succeed. Hence, it is not for beginners or individual investors since you need to match your wits with some of the sharpest brains in the industry. Still, if you are set on short-selling stocks, you should use an investment strategy to limit the risks of shorting. Given the risks, you need to be very careful, well informed and a risk taker to make the most of the stock market. You can seek investment advice from professionals in the industry before you begin shorting.
Joy Wallet is an independent publisher and comparison service, not an investment advisor, financial advisor, loan broker, insurance producer, or insurance broker. Its articles, interactive tools and other content are provided to you for free, as self-help tools and for informational purposes only. They are not intended to provide investment advice. Joy Wallet does not and cannot guarantee the accuracy or applicability of any information in regard to your individual circumstances. We encourage you to seek personalized advice from qualified professionals regarding specific investment issues. Featured estimates are based on past market performance, and past performance is not a guarantee of future performance.
Our site doesn’t feature every company or financial product available on the market. We are compensated by our partners, which may influence which products we review and write about (and where those products appear on our site), but it in no way affects our recommendations or advice. Our editorials are grounded on independent research. Our partners cannot pay us to guarantee favorable reviews of their products or services.
We value your privacy. We work with trusted partners to provide relevant advertising based on information about your use of Joy Wallet’s and third-party websites and applications. This includes, but is not limited to, sharing information about your web browsing activities with Meta (Facebook) and Google. All of the web browsing information that is shared is anonymized. To learn more, click on our Privacy Policy link.
Images appearing across JoyWallet are courtesy of shutterstock.com.
Writer
Vandita Jadeja is a financial writer and editorial assistant at Joywallet. She loves to read and write about money and brings 7 years of experience from the financial industry. She loves coffee, mountains and sunsets.
Share this article
