Shorting a Stock: What Investors Need to Know About Short ...

Short selling is when a trader borrows shares from a broker and immediately sells them with the expectation that the stock price will fall ... Manyoralloftheproductsfeaturedherearefromourpartnerswhocompensateus.Thismayinfluencewhichproductswewriteaboutandwhereandhowtheproductappearsonapage.However,thisdoesnotinfluenceourevaluations.Ouropinionsareourown.Hereisalistofourpartnersandhere'showwemakemoney.Theinvestinginformationprovidedonthispageisforeducationalpurposesonly.NerdWalletdoesnotofferadvisoryorbrokerageservices,nordoesitrecommendoradviseinvestorstobuyorsellparticularstocks,securitiesorotherinvestments.Thecommonlyunderstoodwayinvestorsmakemoneyoffstocksissimple:Buyastockwiththeanticipationthatitspricewillriseovertime,andifitdoes,sellitlaterforaprofit.(Notsurehowthisworks?Brushuponhowtobuystocks.)Thisisconsidered“goinglong.”Butstocksdon’thavetogoupforinvestorstomakemoneyoffthem.Investorsalsocanprofitifthestockpricefalls—andthisistheinfamousshortsell.Whatisshortselling?Shortsellingiswhenatraderborrowssharesfromabrokerandimmediatelysellsthemwiththeexpectationthatthestockpricewillfallshortlyafter.Ifitdoes,thetradercanbuythesharesbackatthelowerprice,returnthemtothebrokerageandkeepthedifferenceasprofit.Here’sanexample:Youborrow10sharesofacompany(oranETForREIT),thenimmediatelysellthemonthestockmarketfor$10each,generating$100.Ifthepricedropsto$5pershare,youcoulduseyour$100tobuybackall10sharesforonly$50,thenreturnthesharestothebroker.Intheend,younetted$50ontheshort(minusanycommissions,feesandinterest).Thatsoundssimpleenough,butthere’salotmoretoshortsellingstocksthanjustunderstandingtheconcept,andthestrategycomeswiththeriskofseriouslosses.Whyshortastock?Investorsmayuseashortingstrategyasaformofspeculation.Inotherwords,it’sahigh-riskmaneuverthatcouldpossiblyyieldhighreturnsinexchangefortakingonexceptionalrisk.Wherealong-terminvestormaybasetheirdecisiononthoroughexaminationofthecompany’sfinancials,managementandfuturepotential,aspeculatormaybasetheirdecisiononanalysisofshort-termpricemovementswiththehopeofquickprofits.Shortingastockalsocanbeusedasahedge.Let’ssayyouownsharesinacompanyandhavedoubtsaboutitsnear-termperformance,butdon’twanttosellyourshares.Inthisinstance,youcouldcontinueholdingyoursharesforthelong-termwhileyoushortthestock,buyingbackinatalowerpriceifandwhenthestock’svaluefalls.Thegoalhereistooffsetthelossesofyourlongposition.HowtoshortastockFirstyou’llneedamarginaccount.Borrowingsharesfromthebrokerageiseffectivelyamarginloan,andyou’llpayinterestontheoutstandingdebt.Theprocessforobtainingamarginaccountvariesbybrokerage,butyou’llprobablyneedtobeapprovedforit.Tomakethetrade,you’llneedcashorstockequityinthatmarginaccountascollateral,equivalenttoatleast50%oftheshortposition’svalue,accordingtoFederalReserverequirements.Ifthisissatisfied,you’llbeabletoenterashort-sellorderinyourbrokerageaccount.It’simportanttonoteherethatyouwon’tbeabletoliquidatethecashyoureceivefromtheshortsale.Tomaintaintheshortposition,theinvestormustkeepenoughequityintheaccounttoserveascollateralforthemarginloan—atleast25%perexchangerules.However,brokeragesmayhaveahigherminimum,dependingontheriskinessofthestocksaswellasthetotalvalueoftheinvestor’spositions.Youcanmaintaintheshortposition(meaningholdontotheborrowedshares)foraslongasyouneed,whetherthat’safewhoursorafewweeks.Justrememberyou’repayinginterestonthoseborrowedsharesforaslongasyouholdthem,andyou’llneedtomaintainthemarginrequirementsthroughouttheperiod,too.Ifthestockpricefalls,you’llclosetheshortpositionbybuyingtheamountofborrowedsharesatthelowerprice,thenreturnthemtothebrokerage.Keepinmindthattoearnaprofit,you’llneedtoconsidertheamountyou’llpayininterest,commissionandfees.Butwhatifthestockpricerises?Inatraditionalstockpurchase,themostyoucanloseistheamountyoupaidfortheshares,buttheupsidepotentialistheoreticallylimitless.Whenyoushortastock,it’stheopposite—gainsaremaxedoutatthetotalvalueoftheshortedstockifthestockpricefallsto$0,butyourlossesaretheoreticallylimitless,becausethestockpricecanriseindefinitely.Let’slookatthesameexampleasabove.Youborrow10sharesandimmediatelysellthemfor$10each,generating$100.Butthenthesharesrallyto$50each.Remember,you’reonthehookforreturningthesharestothebrokeratsomepoint,meaningyoumayhavetobuythembackfor$500— alossof$400.Ifthesharesrallyto$100each,you’dhavetobuythembackfor$1,000foralossof$900.This,intheory,cangoonindefinitely,andthelongeryouwaitforthestockpricetofallagain,thelongeryou’repayinginterestonthoseborrowedshares.Ifthishappens,ashort-sellermightreceivea“margincall”andhavetoputupmorecollateralintheaccounttomaintainthepositionorbeforcedtocloseitbybuyingbackthestock.Giventhemarket’slong-termupwardbias,manyinvestorsfindithardtoshortstocksandachieveconsistent,profitableresults.What’smore,therisk—especiallyifyou’renotsurewhatyou’redoing—ismuchhigherthanabuy-and-holdstrategy.Short-sellingcontroversyShort-sellersreceiveallkindsofcriticism.They'vebeenaccusedofhurtingbusinesses,manipulatingpublicopinionandspreadingrumorsaboutacompanyorstock.It'sevenbeenimpliedthatshort-sellersarealmostunpatrioticfornotsupportingpubliclytradedcompanies.Butshort-sellersoftenbringnewinformationtolight,leadingthemarkettoamoresoberassessmentofacompany’sprospects.Thatcanhavetheeffectofkeepingastockatalowerpricethanitwouldhaveifonlycheerleaderswereonthesideline.Theshortshelpkeepunbridledenthusiasmincheck,andoftentheyuncoverfraud,aggressiveaccountingorjustpoorlyruncompanies,informationthatmaywellbehidinginacompany’sfilingswiththeSecuritiesandExchangeCommission.Theseareallvaluablefunctionsinthecapitalmarkets.Abouttheauthors:JamesF.Royal,Ph.D.,isaformerNerdWalletwriter.Hisworkhasalso beenfeaturedintheWashingtonPost,NewYorkTimesandtheAssociated Press.ReadmoreChrisDavisisaNerdWalletinvestingwriter.Hehasmorethan10yearsofagency,freelance,andin-houseexperiencewritingforfinancialinstitutionsandcoachingfinancialwriters.ReadmoreOnasimilarnote...FindabetterbrokerViewNerdWallet'spicksforthebestbrokersof2022.SeethelistRetirementCalculatorHowtoInvestinStocksWhatisanIRA?GuidetoIndividualRetirementAccountsIndexFunds:HowtoInvestandBestFundstoChooseDiveevendeeperinInvestingBestOnlineBrokersforStockTradingbyKevinVoigtReadmoreBestOnlineStockBrokersforBeginnersbyKevinVoigt,SabrinaParysReadmoreBestRobo-AdvisorsbyAlanaBensonReadmoreExploreInvestingGetmoresmartmoneymoves–straighttoyourinboxSignupandwe’llsendyouNerdyarticlesaboutthemoneytopicsthatmattermosttoyoualongwithotherwaystohelpyougetmorefromyourmoney.Signup