Short Selling

Short selling, often called “shorting,” lets investors profit when a stock’s price falls by borrowing shares and selling them at the current price, then buying them back later at a lower price to return to the lender. It’s a strategic move used mostly by experienced traders around the world but involves notable risk.

How Does Short Selling Work?

To short sell a stock, you first borrow shares from your broker — typically from their inventory, other clients’ margin accounts, or other lenders. You immediately sell the borrowed shares at the current market price, depositing the proceeds into your account. After some time, if the stock price indeed falls, you buy back the same number of shares at this lower price. You then return the shares to your broker and keep the difference as profit, minus any fees or interest.

For example, if you short sell 100 shares at $50 each, you receive $5,000. If the price drops to $30 per share, buying back the shares costs $3,000, resulting in a gross profit of $2,000 (before fees).

Risks of Short Selling

Short selling carries high risks. If the stock price rises instead of falls, you face potentially unlimited losses because a stock’s price can theoretically climb indefinitely. Using the above example, if the stock rises to $70 instead of falling, buying back 100 shares would cost $7,000, a $2,000 loss.

Additionally, short sellers must operate through a margin account, which lets brokers lend stocks but also subjects sellers to margin calls if their positions move against them. A margin call requires you to deposit more funds or close your position, often at a loss. The broker may forcibly cover the short to limit losses.

Another risk is the “short squeeze,” where rapid price increases force many short sellers to buy back shares simultaneously, driving prices even higher. A famous example is GameStop’s surge in early 2021.

Short sellers are also responsible for paying any dividends declared during the loan period and may pay interest on borrowed shares, which further affects profitability.

Who Can Short Sell Stocks?

To short sell, investors generally need a margin account approved for such trades, sufficient capital to meet margin requirements, and broker approval based on experience and risk tolerance. This makes it less accessible to new or casual investors.

Common Myths

• Short sellers are unpatriotic: In reality, they can help improve market efficiency by revealing overvalued stocks and potential fraud.
• Only hedge funds short sell: Individual investors with margin accounts can short sell, though it’s complex and risky.
• You can make infinite money: Profit is capped at the initial sale price; losses can be unlimited.
• Short selling is easy money: Timing and prediction are challenging; markets can remain irrational longer than a trader can stay solvent.

Short Selling Versus Buying Stocks

Additional Resources

For readers interested in related topics, see our articles on Margin Account and Margin Call.

Final Thoughts

Short selling is a sophisticated trading strategy that can benefit investors by profiting from stock price declines or hedging other positions. However, its significant risks — including unlimited losses, margin calls, and short squeezes — make it suitable only for experienced investors who understand its mechanics thoroughly. For most individuals, focusing on long-term investing strategies remains the safer approach.

References

• IRS Publication 550, Investment Income and Expenses: https://www.irs.gov/publications/p550
• Securities and Exchange Commission (SEC) Short Selling Information: https://www.sec.gov/fast-answers/answersshortsaleshtm
• Investopedia, “Short Selling”: https://www.investopedia.com/terms/s/shortselling.asp
• FINRA, “Short Selling FAQs”: https://www.finra.org/investors/learn-to-invest/advanced-investing/short-selling