What Does Shorting a Stock Mean? | The Motley Fool

Shorting a stock means opening a position by borrowing shares that you don't own and then selling them to another investor. 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Follow@TMFMathGuy Shortingastockmeansopeningapositionbyborrowingsharesthatyoudon'townandthensellingthemtoanotherinvestor.Shorting,orsellingshort,isabearishstockposition--inotherwords,youmightshortastockifyoufeelstronglythatitssharepricewasgoingtodecline.  Short-sellingallowsinvestorstoprofitfromstocksorothersecuritieswhentheygodowninvalue.Inordertosellshort,aninvestorhastoborrowthestockorsecuritythroughtheirbrokeragecompanyfromsomeonewhoownsit.Theinvestorthensellsthestock,retainingthecashproceeds. Theshort-sellerhopesthatthepricewillfallovertime,providinganopportunitytobuybackthestockatalowerpricethantheoriginalsaleprice.Anymoneyleftoverafterbuyingbackthestockisprofittotheshort-seller. Asanexample,let'ssaythatyoudecidethatCompanyXYZ,whichtradesfor$100pershare,isoverpriced.So,youdecidetoshortthestockbyborrowing10sharesfromyourbrokerageandsellingthemforatotalof$1,000.Ifthestockproceedstogodownto$90,youcanbuythosesharesbackfor$900,returnthemtoyourbroker,andkeepthe$100profit.  Whenshort-sellingmakessense Atfirstglance,youmightthinkthatshort-sellingwouldbejustascommonasowningstock.However,relativelyfewinvestorsusetheshort-sellingstrategy. Onereasonforthatisgeneralmarketbehavior.Mostinvestorsownstocks,funds,andotherinvestmentsthattheywanttoseerise invalue.Thestockmarketcanfluctuatedramaticallyovershorttimeperiods,butoverthelongtermithasaclearupwardbias.Forlong-terminvestors,owningstockshasbeenamuchbetterbetthanshort-sellingtheentirestockmarket.Shorting,ifusedatall,isbestsuitedasashort-termprofitstrategy.  Sometimes,you'llfindaninvestmentthatyou'reconvincedwilldropintheshortterm.Inthosecases,short-sellingcanbeawaytoprofitfromthemisfortunesthatacompanyisexperiencing. Eventhoughshort-sellingismorecomplicatedthansimplygoingoutandbuyingastock,itcanallowyoutomakemoneywhenothersareseeingtheirinvestmentportfoliosshrink. Therisksofshort-selling Short-sellingcanbeprofitablewhenyoumaketherightcall,butitcarriesgreaterrisksthanwhatordinarystockinvestorsexperience. Specifically,whenyoushortastock,youhaveunlimiteddownsideriskbutlimitedprofitpotential.Thisistheexactoppositeofwhenyoubuyastock,whichcomeswithlimitedriskoflossbutunlimitedprofitpotential.Whenyoubuyastock,themostyoucanloseiswhatyoupayforit.Ifthestockgoestozero,you'llsufferacompleteloss,butyou'llneverlosemorethanthat. Bycontrast,ifthestocksoars,there'snolimittotheprofitsyoucanenjoy.It'squitecommonforlong-termstockinvestorstoearnprofitsthatareseveraltimesthesizeoftheirinitialinvestment.  Withshort-selling,however,thatdynamicisreversed.There'saceilingonyourpotentialprofit,butthere'snotheoreticallimittothelossesyoucansuffer.Forinstance,sayyousell100sharesofstockshortatapriceof$10pershare.Yourproceedsfromthesalewillbe$1,000. Ifthestockgoestozero,you'llgettokeepthefull$1,000.However,ifthestocksoarsto$100pershare,you'llhavetospend$10,000tobuythe100sharesback.Thatwillgiveyouanetlossof$9,000--ninetimesasmuchastheinitialproceedsfromtheshortsale.Andifyouthinklosseslikethisaren'tpossible,thinkagain.  Still,eventhoughshort-sellingisrisky,itcanbeausefulwaytotakecalculatedpositionsagainstaparticularcompanyforinvestorswhoknowwhatthey'redoing. Managingyourriskisimportant,butwhenusedinmoderation,short-sellingcandiversifyyourinvestmentexposureandgiveyouanopportunitytocapturebetterreturnsthansomeonewhoonlyownsstocksandotherinvestments. Related:WhatisShortCovering? Alternativetoshorting Asafinalthought,analternativetoshortingthatlimitsyourdownsideexposureistobuyaputoptiononastock. Essentially,aputoptiongivesyoutheright,butnottheobligation,tosellastockatapredeterminedprice(knownasthestrikeprice)atanytimebeforetheoptioncontractexpires. Forexample,ifyoubuyaputoptioninastockwithastrikepriceof$100andthestockdropsto$60,youcanthenbuysharesfor$60andexerciseyouroptiontosellthemfor$100,therebyprofitingfromthedeclineinthestock. So,theideabehindbuyingaputoptionissimilartoshorting,althoughthemostyoucanpossiblyloseiswhatyoupayfortheputoption.Now,there'smoretotradingoptionsthanIcanexplainhere,sodoyourhomeworkifthisisastrategythatsoundsappealingtoyou.Butitcanbeasmartalternativetotheunlimitedlossexposurethatcomeswithshortingastock.  ExpertQ&A TheMotleyFoolhadachancetoconnectwithanexpertonshorting:SofiaJohan,anassociateprofessorinthefinancedepartmentofFAU'sCollegeofBusiness. SofiaJohan,anassociateprofessorinthefinancedepartmentofFAU'sCollegeofBusiness.Herareasofexpertiseandresearchinterestincludelegalandethicalissuesinfinancialmarkets,entrepreneurialfinance,andregulationoffinancialmarketsaroundtheworld. TheMotleyFool:Whataresomecommonmisconceptionsaboutshortsellingthatinvestorsshouldknow? Johan:Ithinkmostinvestorsbelievetheriskstobethesameasthatoftakinglongpositions.Definitelynotthecase.Somerisksare,ofcourse,similar,forexampletradingonmisinformation.Shortsellershaveanincentivetoprovidefalseinformationtopushstockpricedownbutrememberthatforshortsellersthereistheaddedcostofborrowingthestockthattheyhavetoconsiderwhentheysuccumbtoherdmentality.Thisisn'tanewgame.Moresophisticatedinvestorssuchashedgefundshavebeenstraddlingthelong/shortmarketforages.Havingvotingrightsduetolongpositionsthatenablethemtofacilitatestockpricemovementsandhavingsettingoffcapabilitieswithshortpositionsmakeforpotentiallyhighvolatility.AsImentionedearlier,themarketmaynotbeasefficientasthelesssophisticatedinvestorthinks.Forexample,takenakedshorts.Ifthesellerneverintendstodeliver,thentheoreticallythesellercouldsellasmanysharesasthesellerwants--possibly10timesmorethantheactualnumberoffloatedsharesanddrivethepricedowntozero--untilmarketregulatorsstepin. 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