How to Short Stocks
In “The Big Short,” hedge fund managers Michael Burry and Steve Eisman correctly predicted the collapse of the US housing market. They used investment vehicles called credit default swaps to bet against mortgage-backed securities.
This bet is the aforementioned “Big Short” — an investment that makes money when the price of security declines. Most investors buy stocks of companies they believe in, hoping to make money off their future profits.
Short sellers do the opposite, borrowing shares to bet against companies they believe will tumble. But short selling isn’t this cut and dry compared to buying — especially regarding the risks.
Usually, shorting a stock goes like this: you identify an overvalued security and wish to take an opposite position. To do this, you don’t buy the stock outright. You borrow the stock from your broker and immediately sell it.
You eventually need to return the shares to your broker, but you anticipate the share price being much lower when it comes time to settle up (which is called covering your short).
If the stock you borrowed declines 10%, you can buy the shares on the open market and return them to your broker. You’ve now made a 10% profit on the trade – the difference in the price you sold the borrowed shares for and what you paid when returning them to your broker.
Shorting stocks requires a margin account since you need your broker to lend you the shares in the first place. Borrowing shares from your broker involves the same stipulations as borrowing cash, including interest payments.
(Note: You can also bet on stocks to decline by buying put options. A put option is an agreement to sell a particular security at a predetermined price on or before a specific date. Options don’t require a margin account, but they involve leverage, so be sure to understand how they work before attempting to short a stock in this fashion.)
Here are the basic steps for shorting a stock:
- Check to see if shares are available to borrow (usually, a stock will be marked if it is hard to borrow — HTB – but it is different for each broker).
- Place a sell order on the stock you want to short.
- Buy back the shares at a lower price for a profit or a higher price for a loss.
Remember that this can differ from broker to broker, so make sure to reach out to their customer service to understand how the shorting process works.
Important note — shorting stocks can only be down in a margin account, and if you hold a short position overnight, you will be charged interest based on the amount you are borrowing. If your day trades it, you will not be charged interest.
To many investors, short sellers are just the worst. They push down stock prices and profit off the misery of others. But short sellers do serve a few important purposes.
For starters, they tend to root out fraud and misconduct — a sentiment Warren Buffett shared in a 2006 Berkshire Hathaway shareholders meeting.
Additionally, short sellers provide demand for shares and enhance market liquidity. Buffett had no issues with investors who sold Berkshire Hathaway short since they eventually had to buy the shares to cover.
When shorts misfire, they must buy back the stock quickly to prevent more profound losses. Since stock prices don’t have ceilings, losses from short sales can exceed the initial cost of the investment.
When short sellers scramble to cover, it creates a cycle where more sellers are forced to cover to prevent massive losses — this is called a “short squeeze.” Short squeezes cause stock prices to rise rapidly as the market for sellers dries and upward pressure multiplies.
Now that we’ve established that short sellers aren’t evil incarnate, let’s discuss the benefits and drawbacks.
Short selling involves more risk than traditional stock trading, and successful traders use it as part of a larger overall strategy instead of a way of life.
Short selling growing, and profitable companies make very little financial sense. Short sellers, by definition, are looking for weaker stocks with shaky balance sheets, faulty products, or questionable decision-makers.
Sometimes they even find a combination of all three! By looking for stocks with high short interest, you might be able to find companies headed for a downturn.
When buying a stock, your maximum loss is the initial amount you invested — you can’t go below zero. But that’s not true for short selling. When you sell short, you’re borrowing shares and immediately selling them.
Then you wait for the decline before returning them to your broker. But what if the stock soars on news of being acquired and the share price doubles? Short sellers risk losing more than they initially invest if the stock takes the elevator up instead of down.
One of the most common uses of short selling is hedging a long portfolio in case stocks enter a bear market. Short sales are often used as “insurance” against market declines since the short gains will offset the portfolio’s losses.
Many traders also hedge stock purchases with put options to protect against downside risk.
Short selling might sound exciting and glamorous, but it’s a money-losing move in most markets. The simple fact is that bull markets usually stick around longer than bear markets, and shorts will inevitably find themselves on the wrong side of a few trades.