What is short selling, and what’s in it for traders?

Short selling flips the old adage: buy low, sell high. Anticipating that a stock’s price will drop, a short seller performs this action in reverse: first they sell high, then they buy low. The tricky part is that the short seller doesn’t actually own the shares they want to sell.

You actually borrow shares of stock and then sell them in the open market, without ever owning the shares. Then, you must buy back identical shares at a later date to return to the owner. Your goal as a short seller is to purchase the shares back for less cost in the future and net a profit. If the market value of the shares increases during the period when you’re borrowing them, however, you can suffer serious — even unlimited – losses.

Don’t look on short sellers as wet blankets who root for a stock’s price to drop. Short sellers play a valuable role in expressing their contrarian opinion. They act as a counterbalance to exuberance in the marketplace. While short sellers typically become newsworthy or subjects of regulatory scrutiny during sharp market contractions, they are not directly responsible for these rapid market moves downward. They keep the market healthy by providing liquidity at times when the market badly needs it.

Because a short position is the opposite of a long position, many features are the reverse of what you might expect. In particular, when short selling, the potential profit (rather than the loss) is limited to the value of the stock, but the potential loss of short selling is unlimited.

How does short selling work?

Unlike buying common stock, in which it is possible to initiate a position and hold indefinitely, selling short requires you to keep an eagle-eye on the market, since losses on any short position are theoretically unlimited.

  • Borrow Shares – To profit from a decrease in the price of a stock, you borrow shares and sell them, expecting they will be cheaper to buy back in the future. The owner is not notified that you are borrowing shares; they are able to sell the shares anytime.
  • Create a Liability – After borrowing the shares, you must return those shares at a later date. When you decide the time is right or when strongly encouraged (as with a potential buy-in), the shares are purchased in the open market and returned, thereby settling the liability.
  • Margin Account – Prior to initiating a short sale, you must be approved for margin trading by a brokerage like Ally Invest. Over the life of a short position, Ally closely monitors the amount in your account to ensure that you will be able to make good on your liability.

The risks of selling short

When you short common stock, you face several different kinds of risk. First, you have market risk, which simply means the stock price may increase and work to your detriment. You are also at risk of the company taking a corporate action while you are short the stock. This could be something simple like declaring a dividend is paid; or more complex, like spinning off a company or issuing warrants. Either way, this is activity that can cause you significant pain if ignored.

  • Market risk – Because there is no limit on how high a stock can go, the market risk you face as a short seller is potentially unlimited. The higher the stock price goes, the more pain you feel.
  • Dividend risk – The risk of corporate actions is just as serious. When a company decides it will pay a dividend, it declares a record date. The record date is when the company takes attendance of all the shareholders who can receive the dividend. Once the record date is established, the ex-dividend date (ex-date) is usually set for two business days prior.

If you are short the stock at market close on the day before the ex-date, you will owe the dividend. This means it will be deducted from your trading account and paid to the owner of the shares. When shorting 100 shares with a dividend of only a few cents per share, this may not seem worth mentioning. But if you short thousands of shares with even small dividends, this can rack up some big losses for you.

  • Spinoff risk – In the case of more complex events, like a spinoff or issuing warrants, the potential losses can mount even more quickly. Even though you shorted one security to begin with, you could actually become short two securities (or possibly more) at the same time. What’s more, both pieces could move against you. For example, if you were short Altria when the company spun off Kraft back in 2007, all of a sudden you would’ve found yourself short both of these firms and your trade suddenly became more complex to manage.

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