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Buying a stock is often a bet that the stock’s price will go up. But what if you want to bet on a stock price going down?
Short selling is one way to do that, and involves a few extra steps than simply buying a stock.
It also comes with high risk.
How does one short sell a stock?
First, an investor borrows a share of a company, usually from a broker (likely in a margin account).
The investor then sells the share in the market.
If the share price goes down, the investor then buys that share back and closes the loop — by giving the share that it borrowed back to the broker that lent it to them.
The profit is the difference between the price that the investor was able to sell the share for and the price that the investor was able to buy it back at.
It’s important to remember that borrowing a share also comes with a cost.
So for example, if an investor sells a share at $100 and is able to buy it back at $80, the investor made $20. But if the investor paid $5 to borrow the share, the final takeaway profit is $15.
What happens if the stock’s price goes up?
If the investor wants to close the short position (or if the investor is forced to return the share to the broker), they will have to eat the cost if they were wrong about the stock going down in price.
For example, if the investor sold the share at $100 and had to exit the trade with the stock at a price of $120, the investor will have to fork up $20 in addition to any fees and interest associated with borrowing the stock.
One problem with short selling: the losses can be substantially larger than the principal invested. Whereas the most you can lose when buying a stock is the price of the stock itself, a short sell position in a stock at $100 could lose $200 or $300 or more, depending on how high the price rises and when the borrowed share needs to be returned.
Is short selling legal?
Yes. But there are guardrails around how one can short a stock. The Securities and Exchange Commission (SEC), for example, generally prohibits “naked short selling,” in which an investor sells a share on the market that hasn’t actually been borrowed (or “located”).
The Federal Reserve and the Financial Industry Regulatory Authority (FINRA) also require investors to hold a minimum amount of funds in their margin accounts (called a “maintenance margin”) to ensure they are liquid enough to cover any possible losses.
What’s a short squeeze?
In instances where there are many shorts on a stock, a price increase could force those with short positions to cover those stakes at higher prices. As those exiting their positions buy back the stock, the price could rise further, “squeezing” out all the other shorts who may face higher borrowing fees.
The pressure could lead to a run-up in the stock price, which can generate significant volatility.
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