Short selling is quite simple once you understand it, although the mechanics are very different when compared to buying stocks and then selling them for a profit once the price goes up.
To clear up all the confusion, we’ll explain in detail what short selling is, how to short a stock, how much it costs, and what are the risks associated with it. Let’s dive in.
What is short selling, anyway?
When you buy a stock — also known as going long — you’re hoping that the stock will increase in value, so you’ll make a profit when selling it. The plan is to buy low and sell high.
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Short selling — also known as going short — is the exact opposite. When you short a stock, you’re betting that it will go down in value, which will net you a profit if you’re right. The mechanics of going long vs short are a bit different, though. When going short, you’re basically borrowing a stock from someone else, selling it on the market, and then hoping that the price will go down. If it does, you buy it back for less than you sold it for, return it to the owner, and keep the difference — minus expenses.
Shorting stocks can be a bit tricky to understand for beginners, so don’t worry if you still don’t understand everything after reading the paragraph above. We’ll share an example in the section below that will clear up any confusion.
How to short a stock — example
Okay, so let’s take a look at a fictional example. Let’s say PocketToro is a public company, and its stock price is currently $100. You believe that the company is overpriced and that the stock will go down to at least $80, which is a 20% drop.
You do not own any shares of PocketToro at the moment, but I do. And I don’t plan on selling them since — unlike you — I believe the stock will continue to go up. Here’s where we make a deal.
I’ll loan you one share of PocketToro and I’ll charge you an annual interest rate of 3%. So you’ll have to pay me $3 per year in interest, and you’ll also have to return one share of PocketToro back to me eventually.
Once you get the PocketToro share on loan from me, you immediately sell it on the open market for what it’s worth, which is $100 in this example. A year from now, the stock drops 20% just like you predicted, and is therefore valued at $80. You buy one share on the market for $80, give it back to me — along with the interest you owe me — and keep the difference.
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So, you received $100 from selling my stock, and you bought it back for $80 and then returned it to me. That means that you’ve made a profit of $20 ($100-$80=$20). You have to deduct the interest you owe me from the profit you’ve made — $3 in this case — bringing your net profit to $17. Depending on the broker you’re using, you may have to deduct trading fees from that amount as well.
Shorting a stock is a very simple process with most brokers. You just have to click the sell button instead of the buy button, while everything else should stay the same. The broker will match you with an investor that’s willing to borrow you a stock, so you don’t have to go out and find one yourself — that would be a nightmare. I can’t walk you through step-by-step instructions on how to short a stock, since the process differs a bit from broker to broker, but it’s generally a very easy one.
The risk of shorting stocks
Fact: Going short on a stock is a lot riskier than going long. You can lose a lot more money than you’ve invested, so shorting definitely isn’t for everyone.
Let’s take a look at an example again. If PocketToro’s stock is valued at $100 and you go long, the most you can lose is your initial investment — so, $100. That is because the stock can’t go lower than zero, which will only happen if the company goes bankrupt.
Now let’s say that you short the same stock that’s currently priced at $100. The amount of money you can lose is technically unlimited. That’s because there’s no upper limit on how much the stock price can increase for. Sooner or later, you’ll have to buy the stock back and return it to the owner. If the price of the stock increases by 100% to $200, your initial investment is gone. That’s because you received $100 when selling the stock, but now you have to pay $200 to buy it back — which means you’re down $100.
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Let’s theoretically say that the stock increases from $100 to $1,000. You buy it back at $1,000 to return it to the owner, but since you’ve only received $100 when selling it, you’re in the hole for $900 ($1,000-$900=$100).
As you can see, shorting a stock is a lot riskier than buying a stock and hoping it will increase in value. However, you can minimize the risk by using stop losses, which will limit the amount of money you can lose. When shorting, setting stop losses is a good idea.
Shorting stocks: Expenses
Going short is more expensive than going long. When going long, the only expenses you have are the trading fees set by your broker — if there are any. When going short, you also have to pay a borrow fee, which is an annual interest paid to the owner of the shares. In reality, that fee is usually divided between the broker and the investor that loaned out the shares.
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The borrow fee depends on the stock. The harder it is to find someone to loan you a share, the higher the borrow fee. It’s just basic supply and demand in all its beauty. For a company like Apple, for example, which has a lot of shares available for shorting since investors are willing to lend them out, the borrow fee is quite low. At Interactive Brokers, for example, the annual fee is around 0.25%. That means you’ll pay $25 of interest per year on a $10,000 investment.
When it comes to stocks that are harder to short — harder to find someone to loan them to you — the borrow fee gets very high. The fees can change quite quickly, but I’ve seen them go up way over 50% per year, which is just absurd.
Short selling FAQs
Click on any of the questions below to see the answer.
It has a bad reputation since short sellers contribute to the downfall of the market. Generally, if there are more sellers than buyers for a certain stock, that stock price goes down. And most investors want to see stocks go up over the long run.
Yes, you need a margin account to short stocks. You can’t do it with a cash account, as you’ll have to borrow stock to get the job done.
Talk to your broker. Most of them have a program you can sign up for that will let you loan stocks to others. You won’t have to do anything besides signing up, as you’re broker will do all the heavy lifting.
Yes, you can short ETFs.
Yes, you can lose a lot more than your account is worth when short selling, as there’s no limit on how high the price of a stock can go. That makes shorting very risky.
