What does it mean to ‘short’ a stock? Basically, to short a stock means that the investor expects the stock price to decrease.
Short selling means that you expect the price to decrease. Whether that’s a single stock, the entire sector, or anything in between.
It’s like betting on the losing horse. Would you bet for that?
In general, investing in the stock market can be experienced as difficult by some and risky by others. I am here to tell you investing in the stock market does not have to be hard or complicated.
Here are your resources to check out:
- 5 Simple Steps To Investing Your First Dollar
- How To Get Over Your Fear Of The Stock Market & Start Investing
- Your Guide To Low-Cost Index Funds (Make Investing Affordable)
- How To React To Stock Market Drops?
What Does It Mean To Short A Stock?
Short selling is a strategy that investors use when they expect a decline in the stock (or other forms of equity). It’s an advanced strategy and in the entire process, you never own the stock you’re shorting.
Short selling is an advanced investing strategy that can be used in a variety of ways: traders use short selling as a form of speculation, and investors may use short selling as a way to protect their other investments – this is called hedging.
When you’re speculating by short-selling stocks, you’re taking a big risk. On the other hand, when you’re hedging by short-selling stocks, you’re protecting another position you currently have. This generally reduces risk.
What Is Short Selling?
When you’re short selling a stock, you open a position by borrowing stock that you believe will decrease in value. On a set future date, you can sell your short stock against the market price. You’re betting that the stock that you borrowed will be lower in price when you have to give them back.
That is exactly why the risk is so big. You’re borrowing the stock at price A and need to return them for price B. In theory, the value of the stock can climb indefinitely, making it very risky when you actually need to return the stock. The loss is unlimited – theoretically.
- Shorting a stock means that an investor buys shares and sells it in the market, planning to buy it back later at a lower price.
- Short sellers benefit when the price goes down, so that’s what they bet on.
- Short selling has an extremely high risk/reward ratio – you can get big gains and accumulating assets from it BUT the losses can accumulate very quickly.
Examples Of Short Selling
An investor thinks that Stock A is overpriced at $100 per share and it will decline in value. The investor borrows 100 shares from a broker and sells those shares to the market at $100, totaling $10,000. The investor is now ‘short’ 100 stocks – it has sold something that they borrowed from someone else.
As you expected, the stock price falls to $90 a share. That means you can buy back the shares at $90 a share, for $9,000, and return them to your broker. That means you’ve just earned $1,000 – excluding fees.
This is an example of a successful short. What if you are not so successful because the stock price rises? Let’s look at that.
You have Stock A, and buy 100 shares for $100 per share. The earnings were better than expected, making for a $110 price per stock. Now you have to buy your shares back at $110 per share, totaling $11,000, and return them to your broker. That means you’ve just lost $1,000.
Short Selling As A Hedge
Besides speculation, short selling can also be done for the purpose of hedging – which should offset the price movement of the asset you currently have. This is a lower-risk way because you want to protect your assets and lower the risk of your investment.
When you hedge, you want to make sure to reduce losses and keep your gains. Hedging can be very costly, so it’s not something that every investor is doing regularly. You need to pay for the fees that come with short trading, plus you are capping your gains when the market value increases.
Risks Of Short Selling
There are a couple of very big risks associated with short selling:
- Losing Money – you can lose money when a stock price rises. This downside can be unlimited, as stock prices can increase unlimitedly in theory.
- Unfortunate timing – it can take a while before the stock market reacts to an overvalued stock. It can be the case that your short position is already closed by then.
- Short squeeze – when the stock price is rising, short-sellers are covering their positions by buying back the stock to reduce losses. When they do so, the demand causes the price to rise, which in turn attracts more short-sellers. This is known as a short squeeze.
- Using Leverage – when you’re using leverage and investing with borrowed money, there is an additional risk of you losing that money. Brokers make it easy to lend money from them when you want to keep your short positions open, using your investments as a guarantee. If you make big losses, you have to put in more of your own money – otherwise, they need to close your short position.
- Going against the herd – while it’s not always bad to go against the herd, as mentioned by Warren Buffett, it may be a good idea to check out the general trend of the stock market. Over the course of history, the stock market has gone up. Short selling is betting against the natural movement of the market.
Pros And Cons Of Short Selling
- Opportunity for high profits
- Possibility to leverage
- As a protection (hedge) against other holdings
- Unlimited losses
- Short squeezes
- Pay interest on leverage
- Go against the market’s natural movement
Short selling can cost a LOT of money when the investor takes the wrong guess at the price movement. When you buy the stock, you can only lose up to 100% of the value you have invested. When you decide to short the stock, you can lose much much more than that, since the upside of a stock price is unlimited.
The moment you try to sell your short position, the investor may have problems when buying back the shares. The price may start to increase, triggering a lot of short sellers to buy back, resulting in a short squeeze that makes the price temporarily increase.
With short selling, you are basically betting that the market is going in the opposite direction of the natural movement of the market. You think it will go down instead of up. This can bring again a higher risk.
However, if you rake this higher risk you may be rewarded for that. When the investor guesses the price moves correctly, the return they get can be very rewarding. Especially when they are trading with leverage, not much of their own capital is needed for initial investments.
If you know what you’re doing, short selling can be a great way to hedge certain holdings in your portfolio by providing a counterbalance.
All In All – What Does It Mean To Short Sell A Stock?
Shorting is an interesting transaction for sure. You’re selling stocks that you have borrowed from someone else, hoping to make a profit from it. The goal with shorting is to sell high and buy back low, which is the opposite of what is normally happening.
Shorting is a risky business and should only be done if you really know what you’re doing!
Have you ever short a stock?
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Marjolein is a financial consultant who has built over €4,000 monthly passive income and saves over 70% of her income. Read Radicals’ inspiring story, from stuck in the 9-to-5 to loving life. Feel free to send Radical a message at the bottom of this page