When the average person thinks about making money as an investor, they think of riding the wave as a stock climbs in value. However, there are many ways to make money in the stock market. Even in troubling times, known as bear markets, investors can turn profits.
But how do people make money when stock prices are on a seemingly unbreakable downward trend?
Sure safe-haven investments are great in bear markets when prices fall, but they’re not known to experience significant price growth. Isn’t there a way to realize significant gains when the overall market is going in the opposite direction?
Yes! It’s known as short selling.
What Is Short Selling?
When you invest based on the “buy low, sell high” concept — buying a stock and holding it until its price increases — in stock market jargon this is called taking a long position.
The idea comes from the act of buying a stock at what you think is a low price and holding it for the long haul until it reaches a valuation that you believe to be the top.
On the other side of the coin, you also have the option to take short positions, also known as shorting a stock or short selling.
Short selling is a form of margin trading, which essentially means you’ll be making your trades with borrowed money. However, when shorting, rather than borrowing cash to buy assets or contracts, you’re borrowing shares of stock.
Essentially, if you think a share price is headed lower, shorting allows you to borrow shares of the stock from your broker and sell these borrowed shares on the open market immediately at the current market price.
The shares are often taken from investor accounts with long positions in that stock. Of course, at some point, you’ll have to return the shares you borrowed to their rightful owners.
When you take a short position, you’re ultimately hoping that the price of the stock will fall, giving you the opportunity to buy back the shares you owe at a discounted price before returning them to your broker.
Essentially, when you short sell, you’re making a prediction that the price of a stock or other equity is going to fall, and opening a position that allows you to generate profits from the declines.
For example, let’s say stock XYZ is trading at $100 per share, but you believe the share price represents a significant overvaluation and will soon decline. You might decide to sell the stock short, borrowing shares and selling them immediately on the open market for $100 each.
If a week later the price of the stock falls to $90 per share, you could buy back the shares you owe at that price. In this case, you would earn a 10% return before expenses.
Pro tip: Not all online brokers will allow you to short a stock. Firstrade is one of our favorite online brokers for shorting stocks. They offer $0 commission trading plus comprehensive research through Morningstar, Briefing.com, Zacks, and Benzinga.
Additional Costs Associated With Shorting Stocks
Unfortunately, many investors fail to think about costs when making their trades. This can be a painful mistake because high expenses associated with investing or trading in financial markets will cut into your profitability.
When making a long investment, such as buying shares of stock, the costs are relatively minimal, generally working out to a fraction of a penny per share traded, unless you’re trading on margins or in derivatives, which can greatly increase your cost.
On the other hand, shorting stocks comes with higher fees. After all, shorting a stock means borrowing shares. Whenever you borrow money, there will be fees involved in doing so.
These fees for short sellers are called margin rates, which can be as low as less than 1% but can also climb all the way into the tens of percents depending on market conditions at the time of the trade.
There are also tax implications to think about.
When making a long investment in the traditional sense of buying and holding stock, there are tax benefits to holding your position for more than one year. In this case, the returns you receive are considered long-term capital gains and are taxed at a lower capital gains tax rate.
However, short selling follows a relatively short time horizon, with no reason to hold positions for longer than a year. As a result, gains on these trades are taxed at your standard income tax rate, which significantly increases your overall cost associated with the investment.
How Short Sellers Generate Profits
With the additional costs involved in short selling, how exactly do short sellers generate a profit?
The general idea in the stock market is that price movement tends to happen through a series of overreactions, which opens the door to high volume moves in one direction or another on popular stocks.
For example, let’s say a company unveils a new product, exciting investors. This excitement may lead to dramatic gains in the stock, sending the share price far higher than it should go.
Once investors and traders realize the stock is overvalued, they sell shares, taking profits on their investment and sending the stock down — generally lower than it should go.
By finding stocks with recent news that led to an overreaction, and selling the stock short at the high point, there will be plenty of room in the downward direction to make a profit by repurchasing shorted shares at a much lower price.
Take the example above, for instance: You shorted the stock at $100 and it fell to $90 per share the next week. This left $10 of profits before expenses.
Even if you had a 10% per annum interest rate on the margin for the share, you would only pay 0.19% in interest because you only held the position for a week. So, your cost on the trade would be $0.19, leaving you with $9.81 in profits.
That’s great if things go well, which you’ll soon find isn’t always the case.
Short Selling Rules
As with anything else in life, there are rules short sellers must follow when they decide to short a stock. These rules include:
You Must Have a Margin Account
When you sell a stock short, you’re actually taking out a loan in the form of shares of stock, which requires the use of a margin account. Margin accounts aren’t offered by all brokers, and in some cases, you may need to apply for them after you’ve signed up.
Some of the most popular brokers that offer margin accounts based on offering low margin rates include Interactive Brokers, M1 Finance, E*Trade, and Fidelity.
You Must Follow Regulation T
The Federal Reserve Board put Regulation T in place in order to prevent investors from being unable to repay debts incurred through short-sale transactions.
This regulation stipulates that you must have 150% of the value of the short sale available to you at the time the sale is initiated. That includes the full value of the stocks you are trading, plus an additional margin requirement of 50% of the value of the sale.
Requiring borrowers to have the additional margin ensures they are able to return the borrowed shares to their rightful owners, even if the investment moves in the wrong direction.
You Can’t Short a Falling Stock
Short positions can only be taken out on stocks that are moving in an upward direction or not moving at all. You are not allowed to short stocks that are already on a downtrend.
This rule was designed to prevent a form of market manipulation wherein short sellers could theoretically sell any number of borrowed shares of any stock that’s moving downward.
All of these additional sell orders on the market would drive the share price ever lower in a downward spiral and lead to devastating losses for long shareholders.
Short Selling Comes With Significant Risks
Short selling seems like an appealing trading strategy, especially when you hear about hedge funds making massive amounts of money employing it.
But as appealing as it may seem, selling a stock short comes with significant downside risk. Here’s why:
When making a long investment, you have limited losses.
If you invest $100, and the stock falls to $0, the most money you can lose is your $100 initial investment. Although there’s a limit to how low prices can go, there’s never a limit to how much higher prices can rise.
If you short a stock at $100 and that stock’s price flies to $250, you’ll have to repurchase the borrowed shares at $250 — a full 150% increase compared to when you sold it.
Short-Term Predictions Are Often Incorrect
Short-term strategies are based on patterns and trends, with the idea that past performance is generally indicative of future results. Unfortunately, the shorter the time frame, the less time your predictions of price movements have to come to fruition.
The incredibly short-term nature of the average short sale increases your risk.
A Short Squeeze Can Happen In Minutes
The short squeeze is the Achilles’ heel of traders who short stocks. This is when positive news — or even rumors — send the price of a heavily shorted stock upward.
When this happens, those who have shorted the stock race to buy shares and cut their losses, leading to increased trade volume and significantly higher prices. Every uptick on the tape is a downtick for those who have shorted the stock.
In a short squeeze, stock price gains in multiples can be seen in a matter of minutes, devastating those who bet on movement in the other direction.
Margin Call Risk
Every broker has its own margin requirements, but regardless of who you work with, you’ll be required to keep a percentage of the value of your margin loans in cash in your account. This rule is meant to protect these loans from defaulting and the broker from having to foot the bill on bad trades.
When a shorted stock makes a dramatic run higher, it can trigger a margin call, which means your broker requires you to put more money in your account because your losses have become too large and you no longer meet the margin requirements.
Speculating Is Not Investing
Those who sell stocks short are speculators who bank on betting against the trend. Ultimately, the rules stipulate that a stock has to be moving up or sideways in order for short selling to occur, so when you take a short position, you’re making a contrarian bet against the market.
Although there are plenty of great contrarian investors out there, it is one of the most difficult investment styles to master. It requires you to go against the grain, accepting significant risk in hopes of a significant return when all signs point in the opposite direction of your bet.
When to Sell Short
Short selling wouldn’t exist if there weren’t investors who made profits doing it. Although it is risky, there are times when a strategy of betting against upward trends makes sense. These times include bear markets and times of economic uncertainty.
During bear markets, prices across the overall stock market decline. In the beginning of bear markets, some stocks will lag behind others, enjoying flat movement for a period of time before following the rest of the market down.
This is a great time for short selling. Due to the overall market conditions, there’s a strong chance that the value of most stocks will decline. As a result, finding stocks that are overvalued during these conditions gives you an opportunity to catch a downward trend before it happens.
Short Selling Is Taboo
The stock market is known as a battle between the bears and the bulls, but it’s much more than that. It’s a massive community of people working to invest and make money.
That’s why there are so many articles online, so many experts willing to answer your emails, and whole social networks dedicated to connecting members of the investing and trading community.
When you short sell a stock, you’re not only making a prediction that the value of the stock is going down, you’re helping in the process of making that prediction a self-fulfilling prophecy.
When you think about what moves the market, you might think about factors like news, financial statements, and rumors. But what really moves the market is you and me.
Share prices are nothing more than a measure of the supply and demand of the stock in question. When you and everyone else want to buy, you increase demand and reduce supply, sending the stock price up.
When you short sell a stock, you’re joining the selling side of the equation, ultimately helping to drive the price of the stock down, which can lead to significant losses for other members of the community.
In fact, the Big Short Squeeze, led by members of the WallStreetBets group on Reddit, was a concerted effort by retail investors to hand losses to hedge funds that manipulate markets by selling shares short.
The stock market was designed as a way to generate the financial support companies need to innovate and make our lives easier and better. It wasn’t designed to manipulate share values and extract profit based on nothing more than the losses of others, which is how short selling is often viewed.
How to Be Successful as a Short Seller
Regardless of how you feel about short selling and what the process represents, there are plenty of both institutional and retail investors who have made and will continue to make millions taking part in the activity.
If you plan on trying your hand at the short strategy, here are a few tips you should keep in mind:
Don’t Jump on the Bandwagon
If you’re going to short a stock, make sure it’s not already heavily shorted.
Short squeezes aren’t only a way to stick it to what many investors believe to be the bad guys in the stock market, they’re also a way to generate significant gains.
As a result, trading groups look for stocks that are heavily shorted and work together to force the price of those stocks up enough to push a short squeeze into action.
So, you’ll want to make sure that the short percentage of the volume — sometimes presented as a stock’s “short interest” — is less than 10% before shorting any stock to reduce your chances of getting caught up in a short squeeze.
Perform Detailed Fundamental Analysis
When you make a short move in the market, you’re betting on coming declines. Either you’re speculating that something bad is going to happen, or you’ve taken a more measured, analysis-driven approach.
Just as a value investor looks for stocks that are significantly undervalued, you should be looking for stocks that, based on various valuation metrics, are significantly overvalued compared to their peers.
These stocks are the ones most likely to experience significant declines in the near term.
Set Emotions Aside
Emotion is the enemy of the investor. Greed and fear of loss often lead market participants to stray away from their strategies and into significant losses.
For example, a stock you shorted may be up 10% since the short on a great piece of news. You might know you should close your position, but you’re not willing to accept the loss, and you hold out hope the stock will fall back so you can at least break even.
You might find yourself watching as the stock climbs higher and higher, compounding your losses. In this case, having and sticking to a strategy could have minimized your losses.
When investing or trading — especially when doing so using high-risk strategies — it’s important to set your emotions aside and stick to the strategy you’ve chosen.
Short selling may be somewhat taboo, but it has generated massive amounts of money for those who are good at it.
As with any investing strategy that has the potential to yield significantly greater returns than overall market benchmarks, short selling comes with significant risk.
If you have a relatively low or moderate risk tolerance, you’ll want to look into other strategies.
If you’d like to try your hand as a short seller, it’s imperative that you take the time to do adequate research. Never make your bets based on social media messages or an article that suggests doom and gloom ahead.
Instead, dive into the valuation metrics associated with the stocks you’re interested in shorting, and take an educated approach to making your trades.