What is Short-Selling (Shorting) a Stock

What is Short-Selling (Shorting) a Stock

Short selling is a way of capitalising on market downturns or poor performing stocks by betting on the price to go down. This guide explains how to do it.
Updated: Jan 21, 2022
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5 min read

This lesson focuses on short selling, where you bet on a stock to go down in price. In the last lesson, we looked at stop-loss orders. Stop-loss orders can be a valuable tool if you’re planning to get involved in short selling.

I. An Introduction to Short Selling

Short selling is a way of making money when a stock price falls.

Short selling is an alternative form of investing that you can use when you think the price of a stock is going to fall. 

Some of the reasons for going short might be if you think the market is about to hit a downturn, or you might think a specific stock is overvalued.

II. What Is Short Selling (shorting)?

When you sell short, you borrow a share now to buy back later

Short selling is simply the act of borrowing shares from a broker with the aim of selling them back later at a lower price. If you succeed, you get to make a profit on the difference.

When you buy the shares back to repay your broker, this is known as ‘covering’ your position. Until you cover, you still owe the broker its shares. If the market goes the other way, big increases in price can make short-selling very expensive.

Short selling isn’t too difficult to get your head around, but here’s an example to help understand it. Say you short sell a stock (i.e. borrow a share and sell it) at $100, then cover your position (buy it back) at $90. Congratulations, you’ve just made $10! Or a profit of 10%.

Always remember, though, that it can go both ways. If you short a stock at $100 and it rises to $110 before you cover, you’ve lost $10.

III. Benefits of Short Selling

Short selling is a way of benefiting from falling stock prices.

Short sellers can take advantage of individual stock news, wider market conditions, or simply back their judgement of how a stock is going to perform.

Short selling can be a way of investing in bear markets or big market drops. Rather than waiting for stocks to bounce back, which could take a long time, you can bet on stocks or industries to fall.

You can also use leverage to sell short. When you trade with leverage, you put up a small percentage of the total cost of the trade and borrow the rest from your broker. This lets you make significantly bigger trades and can lead to large gains, but increases the risk significantly as well.

IV. Risks of Short Selling

When you sell short you run the risk of losing more than 100% of your investment.

The biggest risk of short selling is that there is no limit to how much a stock can rise. When you buy a stock, the worst possible outcome is the price falling to $0. When you’re short, the price can rise to a value that might be many times the size of your original investment.

Brokers can also play a role in short selling. As you must always borrow shares to be able to go short, they need to be sure you can afford to pay them back if the price rises. Often you have to maintain a certain percentage of the cost in your account to be able to keep selling short.

Occasionally, brokers can demand short sellers close their positions, or a price rise gets so steep the shorts themselves want to get out. This dual pressure of people buying the shares to push the price up, and short sellers needing to buy shares to cover their positions, causes something called a short squeeze.

Although it’s not a complicated idea, short selling the market requires experience. Beginners still trying to learn how to trade shares should steer clear until they have a better understanding of the risks involved.

V. Top Tips to Succeed at Short Selling

Short selling is usually best as a short term strategy.

Most of the time you want to have a short term mindset when selling short. Over time, stocks tend to go up, which can make holding on for too long a risky strategy. If a stock issues dividends, you can lose out every quarter when the dividends are paid out.

It’s always a good idea to thoroughly research the company you want to sell short, along with its main competitors and the state of its industry. Be sure to know why you’re selling short and be ready to react to new developments.

Finally, we learned about stop-loss orders in the last lesson and they can be a great way of protecting yourself against big losses when you sell short. 

Moving on…

In our next lesson, we’re going to discuss initial public offerings.

Well done, you’ve learnt all there is to know about short selling! Although it might seem counter-intuitive and confusing at first, it’s quite a simple idea to get to grips with. It can be a powerful money-making tool but there are a lot of risks involved so you should be careful when you start.

If you want to learn more about other trading techniques, check out our full range of educational articles.

Sources & references
Risk disclaimer

Invezz is a place where people can find reliable, unbiased information about finance, trading, and investing – but we do not offer financial advice and users should always carry out their own research. The assets covered on this website, including stocks, cryptocurrencies, and commodities can be highly volatile and new investors often lose money. Success in the financial markets is not guaranteed, and users should never invest more than they can afford to lose. You should consider your own personal circumstances and take the time to explore all your options before making any investment. Read our risk disclaimer >

Harry Atkins
Financial Writer
Harry was a Financial Writer for Invezz, drawing on more than a decade writing, editing and managing high-profile content for blue chip companies, Harry’s considerable experience… read more.

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