What to know about short selling: How it works, strategies, risks, rewards

Short selling is typically a high-risk, high-reward trading strategy — an alternative to the traditional buy-and-hold investing strategies, although it can be used as a hedge by more advanced investors. Rather than buying a stock in the hope that it will appreciate in value, you can earn money betting against stocks.

While hedge fund managers and professional traders are the prominent players in the short-selling arena, essentially any investor with a margin account can go short on a stock with the best online brokerages.

But are the potential benefits of short selling worth the risks?

In this guide on short selling explained, we'll cover areas such as what does it mean to short a stock, how does shorting work, and the pros and cons of short selling.

What is short selling?

Short selling (aka shorting or taking a short position) is when investors sell borrowed securities in the hope of buying them back for a lower price. Often, shorting involves stocks, but it can involve other assets like bonds, too. You can even short crypto like bitcoin. One way to think of the short selling meaning is that you're betting on the price of an asset going down, whereas traditional investing involves going "long" by buying an asset and hoping to sell it at a higher price later on.

Short selling is often a high-risk, high-reward trading strategy. When it all goes according to plan, short selling can yield impressive returns. You can borrow a stock, sell it, then buy it back at a lower price, keeping the difference between the sale price and what you bought it back for.

However, short selling can also lead to substantial losses if the stock ends up rising and you have to buy it back for more than you sold it for. This risk can be especially pronounced if a short squeeze occurs, such as the one that took place during the GameStop trading frenzy.

To participate in short selling, you must have a margin brokerage account with your broker. You must also meet your broker's initial and maintenance margin requirements.

How short selling works

Retail investors who engage in short selling usually borrow shares from brokers. Brokers will lend stocks from their own inventory, from clients with stock lending agreements, or from other brokers' or financial institutions' inventory. Institutional investors use financial institutions such as prime brokers or custodians to similarly source shares but on a larger scale.

Depending on factors such as how easily the shares can be sourced for shorting, short sellers will pay a daily borrowing fee that's essentially like interest on a loan. Short sellers are also responsible for any dividends paid out while the shares are on loan, which can decrease the short seller's overall profit or exacerbate their losses.

The profit vs. losses depends on if the stock loses or gains value. Eventually, you have to buy back the shares and return them to the lender. In some cases, the shares will be recalled and you'll have to act right away by buying back the shares, or you might simply decide to close out the position yourself to lock in profit or minimize losses. Brokers can also force you to close out a short if it's moving against you too much and you're not meeting the margin requirement.

For example, let's look at how a short sale of XYZ stock might work. Currently, the stock is being sold for $100 per share. You believe the stock's price is primed to fall and short 100 shares for a total sale price of $10,000.

Now, let's assume that your hunch was correct and the share price for XYZ dropped to $80. You buy 100 shares to replace the ones you borrowed for a total cost of $8,000. Excluding borrowing fees (and dividends if they apply), your profit would be $2,000 ($10,000 - $8,000 = $2,000).

But suppose you guessed wrong on XYZ, and the price spikes to $120 per share before you finally decide to close your position (by buying replacement shares) and cut your losses. At $120 per share, you'd have to pay $12,000 to replace the 100 borrowed shares, resulting in a $2,000 loss ($10,000 - $12,000 = -$2,000), not to mention borrowing fees and possible dividend costs.

Legal and regulatory considerations of short selling

Short sellers get a bad rap as manipulative investors who profit off other traders' misfortune, and they generally take the blame for the drop in the price of certain stocks. Despite the suspicions of some investors and policymakers, many advocates say short sellers act as a crucial counterbalance to overly optimistic market valuations.

The SEC, the main securities regulator in the U.S., including for short selling, keeps a close eye on the impact of short selling on the market and has placed some guardrails on this practice to help protect the overall market.

For example, the SEC adopted an "uptick rule" (Rule 10a-1) in 1938 to restrict short selling during downturns. For the most part, short sales could only be made if the sale price was higher than the last sale price or the same as the last sale price but higher than the last sale price that differed from the one it's equal to. But this rule was eliminated in 2007.

However, in 2010, the SEC implemented an alternative uptick rule called Rule 201, which restricts short selling if a security drops by 10% compared to the previous day's closing price. In that case, for the rest of that day and the next, short selling would only be allowed if the price is above the current national best bid. That helps limit short sellers from further driving down the stock by selling below the national best bid price.

Another restriction in the U.S. and several other markets is that traders can not intentionally engage in naked short selling, meaning that you have to borrow shares before selling them, rather than just selling shares you don't own and buying them back later to close the short position.

Aside from these types of overarching regulations, it's also important to pay attention to requirements from your broker. FINRA has some minimum margin requirements, depending on factors such as the price per share, but your broker might have higher requirements. If your shorts lose value, you might have to deposit more cash or buy shares to close some of your shorts, thereby bringing your equity back to an acceptable level.

Advantages of short selling

Short selling, despite its risk, offers several advantages for investors, including:

• Potential for high returns: The main advantage of short selling is that it can lead to high returns by profiting on short-term declines in a stock's value. You might even believe that a stock will gain value in the long term, but shorting stock can help you increase net returns if you can time it to take advantage of short-term dips, albeit this is a difficult strategy.
• Leverage return: Since short-selling is performed using margin, you only contribute a portion of what is needed to make the trade. This may lead to amplified returns. Remember, borrowed funds are essentially loans, so you'll be responsible for paying back the borrowed amount plus stock borrow fees. So while you might only have to put in $500 to short sell $1,000 worth of stock, you'll have to pay back the $1,000 plus any fees, not to mention the risk of amplified losses.
• Enforce fair value prices: Short sellers act against optimistic markets and can identify potentially overvalued assets. In return, this can provide an important counterbalance to asset prices, thereby potentially helping them maintain a fair value and overall market health.
• Increased liquidity: Short selling increases the overall volume of market trades, contributing to the overall liquidity. Increased liquidity helps encourage trade.
• Protect against potential losses: A trader may also decide to go short on stock to hedge against a long position (that is, shares they already own outright). Once the stock's value drops below a certain price, your long position loses money. However, the profits from your short sale can negate those losses.

Is short selling worth it?

Short selling is a bearish or pessimistic move, requiring assets to decline for the investor to make money, which goes against the general trend of asset prices rising over time. It's a high-risk and often short-term trading strategy that requires close monitoring of your shares and the market. Yet there's an unlimited risk of losses, as the more a stock gains, the more a short position loses. For these reasons, it may not be a suitable strategy for individual investors.

For experienced active traders interested in market timing or who have a negative outlook on particular assets, short selling is a strategy that can produce positive returns even in a period of negative returns for a stock or the market as a whole. But if you decide to short stocks, ensure you fully understand the risks and have a clear exit plan for getting out of the short if the stock price rises against you.

Risks of short selling

The big risk of short selling is that you could guess wrong, and the assets you borrowed appreciate. Unfortunately, guessing wrong on a shortened stock is much riskier than traditional investing strategies.

When you buy a stock, your upside is unlimited and the maximum amount you can lose is all of your investment (aka the stock price falls to $0). But shorting stock works the other way around. The upside is limited to the difference between the initial price and the stock going to $0, while the amount you can lose is technically infinite if the stock keeps gaining value.

Suppose you short a stock at $25 per share. if the stock were to drop to $0, your profit would be maximized at $25 profit per share, minus any fees. But if the trade goes against the stock, then it could rise to $50 (100% loss), $75 (200% loss), $100 (300% loss), or even higher.

Other notable risks of short selling include:

• Appreciation trend: The stock market tends to rise over the long term. So, the overall trend is against you as a short seller.
• A short squeeze: This happens when a stock rises sharply and suddenly. Short sellers scramble en masse to buy shares to cover their position. Each buy transaction drives the stock even higher, forcing more short sellers to exit their positions… and the vicious cycle continues. Short squeezes typically happen when a high percentage of all the stock's outstanding shares are sold short.
• Margin dangers: Margin trading adds another layer of risk. If the shorted stock rises significantly in value, the broker could issue a margin call, requiring you to add cash or securities to your account to cover more of what you borrowed. If the margin call isn't met (typically within two to five days), the broker can sell the stock, locking in your losses.

Strategies and techniques in short selling

Figuring out how to short sell effectively requires strategic planning and extensive market knowledge to identify potential stock weaknesses. Common identification techniques include analyzing charting patterns, moving averages, and the relative strength index (RSI).

You can also identify stocks by thoroughly researching a company's financials and keeping up with the news and industry trends. You might identify issues with a company's balance sheet that you think are not properly being priced into the stock.

Of course, it's hard to say if your analysis is correct and other investors are wrong. Even if you're technically right that a stock is trading above comparable companies, for example, that doesn't mean the market overall will agree, at least anytime soon. That's largely why shorting involves so much risk and uncertainty.

Thus, timing is a key element of a successful short selling, because if you can get in as a stock is on or about to enter a decline, you can potentially make a significant profit without having borrowing or margin calls disrupt your strategy. Still, timing the market is incredibly difficult, and it's hard to say if it's truly a skill or luck issue.

Only experienced investors willing to conduct extensive research and make informed trades should participate in short selling. Remember that short selling is a very risky investment strategy that could become costly if the long-term trend of market appreciation works against you.

Risk management in short selling

Thoroughly researching a company's financials and keeping up-to-date with the news and economic trends is only one way to mitigate the risk of short-selling. You can also manage risk by:

• Diversifying investments: Like with any investment portfolio, diversifying your investments can limit losses. If you only put a small amount into short selling, while going long on other assets, you can reduce the risk of large losses. Ideally, you can even gain in both directions, as many hedge funds try to do. For example, you might short a particular tech company, but go long by buying a tech ETF. If the whole industry does well, your short might suffer, but that could be cancelled out by gains in the tech ETF. Or, maybe the company you're shorting does stumble while the rest of the sector performs relatively well, giving you both short and long gains.
• Setting buy-stop orders: With traditional long investing, you can set a stop-loss order that determines a specific stock price where your position will automatically be sold, that way if the price is falling, you can limit your losses. With shorting, the opposite can be put in place with a buy-stop order, so if the stock price rises, you can set a threshold at which you want to trigger a buy order so you can close the short position.

Controversies and challenges of short selling

Short selling continues to be controversial despite regulatory rules to prevent short sellers from manipulating the market.

The main critique of short selling claims that short sellers are predatory investors who unfairly manipulate and take advantage of volatile markets to earn a profit. Short selling can compromise people's confidence in the market and may negatively impact companies and their investors, as it does involve selling stocks that you don't technically own. That can put downward pressure on asset prices.

There have been multiple attempts to ban short selling, but most do not end up sticking long term. Temporary bans are more common as a way to help stabilize the economy, such as the one that took place during the 2008 financial crisis.

Whether or not you agree with the critiques of short selling, it's important to realize that the controversy around it can potentially affect your investment strategy.

If you're a long investor, you might consider the risk of a short attack, where short investors publicize negative information about a company to try to drive down the price. Some companies are better able to handle short attacks than others, such as if the company has cash reserves to support the stock price with buybacks or if it has stable management and a board that can clearly communicate long-term value to other investors.

Or, if you're a short investor, you might consider how the sometimes negative view of shorting leads to investors trying to create a short squeeze. Also, there's a risk that regulatory issues make it harder to short in the future.

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