When it comes to trading and investing there are so many different strategies that can be used to make money from assets. One such trading strategy is short selling. But what is short selling? In this post we’ll explain short selling, how short selling works and look at the pros and cons of this sometimes controversial trading strategy.
Most investors purchase a financial security such as stocks and hold them with the aim of making a profit through rising prices over time. Short selling is the opposite of this. It is a strategy that traders use to bet on prices falling. It is high risk but has potential high reward of making large profits in a very short amount of time. We will explain short selling with the aid of the infographic below.
Learn the difference between trading and investing.
Short selling is sometimes also used by investors as a way to ‘hedge’ their long portfolios. This differs to speculative shorting. It is a strategy to help protect gains or to keep losses to a minimum in an investment portfolio.
How Short Selling Works To Profit From Falling Prices
Short selling or shorting is a form of speculation. A trader opens a short position and borrows a financial security such as stocks through a broker. These securities are then sold to buyers in the open market at the current market price.
As traders borrow the assets, they must return them at a later date to close the position. The trader will hold the position and wait for the asset price to fall. After the price declines, the trader purchases back the asset at a much lower cost then they sold it. The difference in price is their profit (minus any interest fees).
Short selling utilizes margin accounts. These are accounts that allow a broker to lend money to a trader in order to purchase assets. This allows a trader to purchase assets without having to fund the full value of the trade. It is known as leverage which helps magnify both profits and losses. A margin account can be used to fund both long and short positions across a range of assets.
Margin accounts have rules such as margin calls and interest fees applicable on the loaned funds that are important to understand. Plus the potential for high losses if you make the wrong call. Therefore they are only recommended for more experienced and sophisticated traders and investors.
Naked Shorting
There is a type of short selling known as ‘naked shorting’. This method involves short selling an asset without first borrowing the asset or ensuring it can be borrowed. Naked shorting was banned in the United States by the Securities and Exchange Commission (SEC) following the 2008 financial crisis. However it is still legal in other jurisdictions.
What Are The Risks Of Short Selling
Now short selling does have potential to make very high profits if you make the right call and a price declines. However shorting presents some risks. Namely that if the price goes in the other direction and rises you could end up with serious losses.
This is because the price of an asset can theoretically rise infinitely. Even if the price doesn’t reflect the true value it can keep on rising. If you hold a short position then in order to close it, you must purchase back the stock you borrowed. If the price rises you have to purchase the asset back at a higher price than you sold it for, leading to losses.
How Much Profit Can You Make From Shorting?
Shorting has potential for good profits but maximum returns are theoretically limited to 100%. When shorting a stock for instance, it’s price cannot go lower than zero which means it loses 100% of it’s value.
See the table below for a comparison of long and short positions. Note potential profits and losses are the reverse of each other.
Short Selling Example 1: How To Make A Profit
Let’s look at an example for clarity of how short selling can turn a profit. Say you have identified a company that is in decline and whose stock price you believe will soon drop. You try to profit from this by taking out a short position through your broker.
The current stock price is $100, you borrow 100 shares and sell them to an investor at the current market price for a total of $10,000.
A few days later after reporting the latest poor financial results, the company stock price drops 50% and is now worth only $50 per share.
You now decide to close the position to take your profits. To do this you must first purchase back the 100 shares in the company that you borrowed. So you purchase 100 shares at $50 each (total $5,000). You return these to your broker and close the position.
The trader’s profit from the short position is $5,000. (Not including any commission and interest fees charged by the broker)
Calculated as $100 sale price — $50 purchase price = $50 per share. $50 per share x 100 shares = $5,000
Short Selling Example 2: How To Make A Loss
Now let’s take a look at a scenario how you can lose money short selling. Using the same short selling example as above. You open a short position in the same company borrowing 100 shares and selling them at $100 per share for a total $10,000.
You have speculated the financial results will miss forecasts and make a loss, resulting in a drop in the share price. But when the results are released a few days later, something unexpected happens. The company actually turned a profit and exceeded expectations. Instead of falling 50%, the share price actually rises 50%.
This means if you were to close your short position now you would lock in a large loss. As you would have to buy back the shares at considerably more than you sold them for.
The shares now cost $150 each due to the 50% rise in the share price. These 100 shares now cost you a total of $15,000 to re-purchase ($150 x 100). This results in a loss of $5,000.
Calculated as $100 per share sale price — $150 per share purchase price = -$50 per share x 100 = -$5,000. This figure is not including any additional commission and interest fees the broker applies.
Remember when you bet on a stock to fall, it cannot go any lower than zero, so profits are limited. Losses on the other hand are unlimited. This is because there is no upper limit to a stock price, it can continue climbing to infinity.
Each rise in price results in greater loss to a short seller. Which is why it is often best left to experienced traders and investors who have the funds and are prepared to take on the risks.
Short Squeeze Explained
Even the professionals can get caught off guard sometimes. Remember the Meme stock frenzy in January 2021? When individual investors banded en-masse to purchase stock of Gamestop. It was heavily shorted by hedge funds at the time and these investors helped push up the Gamestop stock price by more than 1000% within a week.
The effect this had was that in order to close out losing short positions, those funds had to purchase large volumes of stock at already hugely inflated prices. Which in turn helped drive the stock price up even further. This is known as a ‘short squeeze’ as the shorters get squeezed out of their positions.
What Are The Pros And Cons Of Short Selling?
Like any trading strategy, short selling has both it’s advantages and disadvantages.
Pros;
- Potential for high profits
- A way to make money in a falling market
- Provides a hedge for ‘long’ held assets
- Minimal capital required
Cons
- Loss potential is unlimited
- Profits limited to 100%
- Margin account required
- Margin interest applied
- Susceptible to events such as ‘short squeezes’
- May face increased regulator scrutiny including bans imposed on shorting certain assets
How Short Selling Works Conclusion
So to recap how short selling works. Shorting is a form of speculative trading to make profits from falling prices. Assets are borrowed and sold at their market price with the expectation they will fall in price. After a price reduction, the asset is repurchased and returned to the lender to close out the short position. The difference between the sell price and the buy price is the trader’s profit.
There are several advantages and disadvantages to short selling. On one hand it has the potential to make good profits, especially during bear markets. And as assets are bought ‘on margin’, this reduces the amount of capital required to invest.
On the other hand potential losses from short selling are unlimited. This is because the rising price of an asset such as stocks is theoretically unlimited. As a margin account is required, interest costs must also be factored in to returns.
Shorting is a high risk but high reward trading strategy. Due to the elevated level of risk it is only recommended for more experienced traders and investors. Most individuals are better suited to traditional ‘long’ investments. These also carry some risk but the most you can lose is your entire investment. We recommend viewing these 21 types of investment assets to grow wealth.
Whether you are a trader engaging in short selling or a long term investor, find the right trading and investing platform for you.
