When you invest, you typically buy securities that you expect to rise in price, so that when you’re ready to sell you’ll generate returns. But in a bear market, when stock prices are generally declining, this trading strategy might not be the most effective. That’s when you might bring short selling into play. Read on to learn how to short a stock and why this can be a useful strategy to limit your downside risk — and even make a profit — when stock prices are falling.
What is short selling stock?
Short selling, or shorting a stock, is a strategy used by professional traders and individual DIY investors that can be a means of generating investment income even when stock prices decline. That’s because rather than “buy low, sell high” you do the reverse and “sell high, then buy low.” We’ll explain.
If you speculate a stock’s price will drop in the future, you might bet against the security by short selling it. To do this, you first borrow shares of the stock from a broker, like Ally Invest. Then, you sell those borrowed shares on the open market. Because you must replace the borrowed shares, you will eventually need to buy the stock and return shares to the owner. Your goal is to buy the shares at a lower price than what you sold them for so that you can net a profit.
How does shorting stocks work?
If you want to add shorting stocks to your Self-Directed Trading strategy, you’ll first need to be approved for a margin account with your broker (taking a short stock position involves more restrictions and rules than taking a conventional long position.) This will allow you to buy on margin, meaning you can use borrowed funds from your broker, like Ally Invest, to purchase securities.
When you are approved for margin trading and meet the necessary requirements to open a short position, you initiate the trade by placing a sell short order. Your broker will work behind the scenes to locate available shares for you to borrow. When shares are located and sold, the proceeds will be credited to your account. This creates a liability and you are obligated to return the borrowed shares at a later date.
You will want to closely monitor the stock price as you wait to buy back the shares. If the price goes up, you could potentially suffer major losses, as you’ll have to purchase the stocks back at a higher price than what you sold them. If the price goes down, you can make a profit on the difference between how much you made from selling the borrowed shares and the cost of buying them back.
A Simple Example of Shorting a Stock
Let’s say you are a seasoned trader and you’re confident that stock XYZ is overvalued in the market and will likely experience a price drop in the next couple of weeks. You decide to short 100 shares of the stock at $50 a piece. Your broker locates the shares for you, and you receive $5,000 in your account (keep in mind you may have to pay commission fees, which will be deducted from your proceeds.)
The next week, the share price of stock XYZ drops to $40. You buy 100 shares at the new price for a total of $4,000 and close the short position. At the end of the process, your net gain is $1,000.
But let’s consider what would’ve happened if the share price had increased from the original $50 to $60. You would have purchased the shares for $6,000, and since you only received $5,000 from the original sale of the borrowed shares, you will have to cover the final $1,000 — meaning the entire transaction lost you $1,000 (plus commission fees).
Risks and Benefits of Shorting Stocks
When you take a long position on a stock, the most you can lose is 100% of your investment if the stock becomes worthless and its price drops to zero. But like you read in the previous example, shorting stocks can pose a hefty risk if the price of the stock goes up. In fact, the potential loss when short selling is technically infinite — as the higher a stock price rises, the more you will have to pay to buy back shares. A dramatic increase in price can be seriously damaging, so this risk should not be taken lightly.
It’s possible that when you want to close your short position, you may have trouble finding shares to buy. A stock may become less liquid if it’s thinly traded due to little demand. On the other hand, you might experience what’s called a “short squeeze” when buying back shares. This happens when the price of a stock rises quickly, causing short sellers to scramble to buy the shares before the price continues to increase. In turn, this causes the price to skyrocket even higher — and can be detrimental to all the traders who were banking on a price decline.
Short selling also poses more costs than traditionally buying and holding investments. Some of those costs include margin interest, “hard-to-borrow” fees (for shares that are difficult to locate and borrow), and dividends. That’s because if you are short a stock at market close on the day before a company’s ex-dividend date (a.k.a. the ex-date), you will owe the dividend to the owner of the shares and the cost will come from your trading account.
Of course, with high risk comes the potential for high reward. Short selling offers an opportunity to generate income during bear markets, when buying and holding securities would typically result in losses. And if you predict the downward movement of a stock correctly, you can make a significant return. Plus, short selling doesn’t require you to invest a lot of your own capital if you use margin.
If you’re bearish on a stock, short selling may be a smart strategy to take advantage of price declines. But when it comes to this tactic, timing is crucial and entering a trade too early or too late can result in diminished returns, or worse — losses. Before you head into a trade, it’s important to fully understand the risks of margin trading and the possible outcomes of short selling. That way, you can open your short position prepared and confident.
Interested in adding shorting to your investment strategy? Learn more about margin trading with Ally Invest.