How an Investor Can Make Money Short Selling Stocks

One way to make money on stocks for which the price is falling is called short selling (also known as "going short" or "shorting"). Short selling sounds ... TableofContents Expand TableofContents HowCanShortSellingMakeMoney? ExampleofaShortSale WhatAretheRisks? WhyDoInvestorsGoShort? WhenDoesShortSellingMakeSense? LessRiskyAlternativetoShortSelling CostsAssociatedWithShortSelling ShortSaleFAQs TradingStrategies AdvancedStrategies&Instruments HowCanShortSellingMakeMoney? Onewaytomakemoneyonstocksforwhichthepriceisfallingiscalledshortselling(alsoknownas"goingshort"or"shorting").Shortsellingsoundslikeafairlysimpleconceptintheory—aninvestorborrowsastock,sellsthestock,andthenbuysthestockbacktoreturnittothelender.Inpracticalterms,however,itisanadvancedstrategythatonlyexperiencedinvestorsandtradersshoulduse. Shortsellers arewageringthatthe stocktheyareshortsellingwilldropinprice.Ifthestockdoesdrop afterselling,theshortsellerbuysitbackatalowerpriceandreturnsittothelender.Thedifferencebetweenthesellpriceandthebuypriceistheshortseller'sprofit. KeyTakeaways Shortsellers arewageringthata stockwilldropinprice.Shortsellingisriskierthangoinglongonastockbecause,theoretically,thereisnolimittotheamountyoucouldlose.Speculatorsshortselltocapitalizeonadecline,whilehedgersgoshorttoprotectgainsorminimizelosses.Whensuccessful,shortsellingcannettheinvestoradecentprofitintheshorttermbecausestockstendtolosevaluefasterthantheyappreciate.Inexperiencedinvestorsmayfindthatshortsellingstocksisnottotheiradvantage. ExampleofaShortSale Forexample,supposeaninvestorthinksthatMetaPlatformsInc.(FB),formerlyFacebook,isovervaluedat$200 pershareandwilldeclineinprice.Inthatcase,theinvestorcould"borrow"10sharesofMetafromtheirbrokerandthensellthesharesforthecurrentmarketpriceof$200.Ifthestockgoesdownto$125,theinvestorcouldbuythe10sharesbackatthisprice,returntheborrowedsharestotheirbroker,andnet$750($2,000-$1,250).However,ifMeta'ssharepricerisesto$250,theinvestorwouldlose$500($2,000-$2,500). WhatAretheRisks? Shortsellingsubstantiallyamplifiesrisk.Whenaninvestorbuysastock(orgoeslong),theystandtoloseonlythemoneythattheyhaveinvested.Thus,iftheinvestorboughtoneFBshareat$200,themaximumtheycouldloseis$200becausethestockcannotdroptolessthan$0.Inotherwords,thelowestvaluethatanystockcanfalltois$0. However,wheninvestorsshortsell,theycantheoreticallyloseaninfiniteamountofmoneybecauseastock'spricecankeeprisingforever.Asintheexampleabove,ifaninvestorhadashortpositioninMeta(orshortsoldit),andthepriceroseto$375 beforetheinvestorexited,theywouldlose$175pershare. Anotherriskfacedbyshortsellersisthatofa"shortsqueeze,"inwhichastockwithalargeshortinterest(i.e.,astockthathasbeenheavilysoldshort)climbsrapidlyinprice.Thistriggersasteeperpriceascentinthestockasmoreandmoreshortsellersbuybackthestocktocloseouttheirshortpositionsandcaptheirlosses. ShortSqueeze InJanuary2021,followersofapopularRedditpagecalledWallStreetBetsbandedtogethertocauseamassiveshortsqueezeinstocksofstrugglingcompanieswithveryhighshortinterest,suchasvideogameretailerGameStopCorp.(GME).Thiscausedthecompany'ssharepricestosoar17-foldinJanuaryalone. Shortsellingcangenerallyonlybeundertakeninamarginaccount,atypeofaccountbywhichbrokerageslendfundstoinvestorsandtradersfortradingsecurities.Therefore,theshortsellerhastomonitorthemarginaccountcloselytoensurethattheaccountalwayshassufficientcapitalormargintomaintaintheshortposition. Ifthestockthatthetraderhassoldshortsuddenlyspikesinprice(forexample,ifthecompanyannouncesinitsquarterlyreportthatearningshaveexceededexpectations),thetraderwillhavetopumpadditionalfundsintothemarginaccountrightaway,orelsethebrokeragemayforciblycloseouttheshortpositionandsaddlethetraderwiththeloss. Ifaninvestorshortsastock,thereistechnicallynolimittotheamounttheycouldlosebecausethestockcancontinuetogoupinvalueindefinitely.Insomecases,investorscouldevenendupowingtheirbrokeragemoney. WhyDoInvestorsGoShort? Shortsellingcanservethepurposesofspeculationorhedging.Speculatorsuseshortsellingtocapitalizeonapotentialdeclineinaspecificsecurityoracrossthemarketasawhole.Hedgersusethestrategytoprotectgainsormitigatelossesinasecurityorportfolio. Notably,institutionalinvestorsandsavvyindividualsfrequentlyengageinshort-sellingstrategiesforbothspeculationandhedgingsimultaneously.Hedgefundsareamongthemostactiveshortsellersandoftenuseshortpositionsinselectstocksorsectorstohedgetheirlongpositionsinotherstocks. Thoughshortsellingdoespresentinvestorswithanopportunitytomakeprofitsinadecliningorneutralmarket,onlysophisticatedinvestorsandadvancedtradersshouldattemptitduetoitsriskofinfinitelosses. WhenDoesShortSellingMakeSense? Shortsellingisnotastrategymanyinvestorsuse,largelybecausetheexpectationisthatstockswillriseinvalueovertime.Inthelongrun,thestockmarkettendstogoup,althoughitisoccasionallypunctuatedbybearmarketsinwhichstockstumblesignificantly. Forthetypicalinvestorwithalong-terminvestmenthorizon,buyingstocksisalessriskypropositionthanshortselling.Shortsellingmayonlymakesenseincertainsituations,suchasinaprotractedbearmarketorifacompanyisexperiencingfinancialdifficulties.Thatsaid,onlyadvancedinvestorswhohaveahightoleranceforriskandunderstandtherisksassociatedwithshortsellingshouldattemptit. LessRiskyAlternativetoShortSelling Analternativetoshortsellingthatlimitsyourdownsideexposureistobuyaputoptiononthesamestock.Holdingaputoptiongivestheinvestortheright,butnottheobligation,toselltheunderlyingstockatastatedprice,calledthestrikeprice.Ifthepriceofthestockinquestionrisesratherthanfalls,theinvestor'slossislimitedtotheamountpaidfortheputoption,calledtheoptionpremium,plusanycommissions. Theoptionpremiumwillvarybasedonthestrikepriceandtheexpirationdateoftheputoption.Thehigherthestrikepriceisandthelongerintothefuturetheexpirationdateis,thehighertheoptionpremiumwillbe. UsingsharesofMetaagainasanexample,itwastradingatabout$200onMar.4,2022.Atthattime,aputoptionwithastrikepriceof$200expiringonMar.18,2022,costabout$13pershareintermsofoptionpremium,pluscommissions.Thus,ifthepriceofMetaactuallyroseabove$200,theinvestor'slosswouldbelimitedto$13persharepluscommissions. CostsAssociatedWithShortSelling Tradingcommissionsarenottheonlyexpenseinvolvedwhenshortselling.Thereareothercosts,suchas: MarginInterest:Becauseshortsellingcangenerallyonlybeundertakeninamarginaccount,theshortsellerhastopayinterestontheborrowedfunds. Stockborrowingcosts:Sharesofsomecompaniesmaybedifficulttoborrowbecauseofhighshortinterestorlimitedsharefloat.Inordertoborrowthesesharesforshortselling,thetradermustpaya"hard-to-borrow"feethatisbasedonanannualizedrate,whichcanbequitehighandisproratedforthenumberoftradesthattheshorttradeisopen. Dividendsandotherpayments:Theshortsellerisalsoonthehooktomakedividendpaymentsontheshortedstock,aswellaspaymentsforothercorporateeventsassociatedwiththeshortedstock,suchasstocksplitsandspinoffs. WhatIstheMaximumProfitYouCanMakeFromShortSellingaStock? Themaximumprofityoucantheoreticallymakefromshortsellingastockis100%becausethelowestpriceatwhichastockcantradeis$0.Theactualprofitonasuccessfulshorttradeislikelytobebelow100%afterfactoringinexpensesassociatedwiththeshortposition,suchasstockborrowingcostsandmargininterest. CanYouReallyLoseMoreThanYouHaveInvestedinaShortSale? Yes,youcanlosemuchmorethanyouhaveinvestedinashortsale;intheory,yourlossescanbeinfinite.Thisisthereverseofaconventional"long"strategy,bywhichthemaximumgainonastockyouhavepurchasedistheoreticallyinfinite,butthemostyoucanloseistheamountinvested.Asanexampleofthedevastatinglossesthatcanbeinflictedonashortsalebyrunawaypriceappreciation,considerthissituation.Aninvestorwhohadashortpositionof100sharesinGameStopasofDec.31,2020,wouldbefacedwithalossof$306.16pershare,or$30,616,iftheshortpositionwasstillopenonJan.29,2021.Becausethestocksoaredfrom$18.84to$325.00overthisone-monthperiod,theinvestor'sreturnwouldbe-1,625%. IsShortSellingBadfortheEconomy? Shortsellinghasacquiredanegativeconnotationbecausesomeunscrupulousshortsellershaveusedunethicaltacticstodrivedownstockprices.Butwhenusedinthecorrectmanner,shortsellingfacilitatesthesmoothfunctioningoffinancialmarketsbyprovidingmarketliquidity,actingasarealitycheckforinvestors'unrealisticexpectationsandthusreducingtheriskofmarketbubblesandenablingdownsideriskmitigation. ArticleSources Investopediarequireswriterstouseprimarysourcestosupporttheirwork.Theseincludewhitepapers,governmentdata,originalreporting,andinterviewswithindustryexperts.Wealsoreferenceoriginalresearchfromotherreputablepublisherswhereappropriate.Youcanlearnmoreaboutthestandardswefollowinproducingaccurate,unbiasedcontentinour editorialpolicy. YahooFinance."GameStopCorp.(GME)." YahooFinance."MetaPlatforms,Inc.(FB)." Nasdaq."FBOptionChain." 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Arebateinashort-saletransactionistheportionofinterestordividendspaidbytheshortsellertotheownerofthesharesbeingsoldshort. more PutOption:HowItWorksandExamples Aputoptiongrantstherighttotheownertosellsomeamountoftheunderlyingsecurityataspecifiedprice,onorbeforetheoptionexpires. more WhatDoes"PuttoSeller"Mean? Puttoselleriswhenaputoptionisexercised,andtheputwriterbecomesresponsibleforreceivingtheunderlyingsharesatthestrikepricetothelong. more HowLong-TermEquityAnticipationSecurities(LEAPS)Work Long-termequityanticipationsecurities(LEAPS)areoptionscontractswithexpirationdatesthatarelongerthanoneyear. more