You borrow 10 shares and immediately sell them for $10 each, generating $100. Remember, you’re on the hook for returning the shares to the broker at some point, meaning you may have to buy them back for $500 — a loss of $400. If the shares rally to $100 each, you’d have to buy them back for $1,000 for a loss of $900. This, in theory, can go on indefinitely, and the longer you wait for the stock price to fall again, the longer you’re paying interest on those borrowed shares. Let’s say you own shares in a company and have doubts about its near-term performance, but don’t want to sell your shares.
By contrast, if the stock soars, there’s no limit to the profits you can enjoy. It’s quite common for long-term stock investors to earn profits that are several times the size of their initial investment. Sometimes, you’ll find an investment that you’re convinced will drop in the short term.
Real-World Example of Short Selling
Short-selling regulations vary across jurisdictions outside the U.S.
Such research often brings to light information not readily available elsewhere and certainly not commonly available from brokerage houses that prefer to issue buy rather than sell recommendations. Many brokers allow short selling in individual accounts, but you must first apply for a margin account. Unfortunately, short selling gets a bad name due to the practices employed by unethical speculators. These unscrupulous types have used short-selling strategies and derivatives to deflate prices and conduct bear raids on vulnerable stocks artificially. Most forms of market manipulation like this are illegal in the U.S. but still happen periodically. As the hard-to-borrow rate can fluctuate substantially from day to day and even on an intraday basis, the exact dollar amount of the fee may not be known in advance.
The investing information provided on this page is for educational purposes only. NerdWallet, Inc. does not offer advisory or brokerage services, nor does it recommend or advise investors to buy or sell particular stocks, securities or other investments. Before attempting to sell short, enroll in one of the best investing courses you can find to learn more about the risks, rewards, and trading techniques of this investment https://www.dowjonesrisk.com/ strategy. Short-selling gives traders a whole new dimension of forex price movements to speculate on – as traders can make money even if the value of the FX pair drops in price. On the other hand, short-sellers are often blamed for causing or aggravating a downswing to make more profit. What makes short-selling different is that you would take the position only if you have a negative outlook on an asset’s performance.
Regulatory risks
Keep in mind that the short-selling process may be slightly different depending on the brokerage. You also need a margin account to sell short, so you should contact your broker to make sure you have the proper permissions. When a share starts gaining, instead of falling, that’s trouble for the short seller. Losses are theoretically infinite since there’s no limit to how high a share price can go.
- There’s a ceiling on your potential profit, but there’s no theoretical limit to the losses you can suffer.
- Before attempting to sell short, enroll in one of the best investing courses you can find to learn more about the risks, rewards, and trading techniques of this investment strategy.
- But short sellers often bring new information to light, leading the market to a more sober assessment of a company’s prospects.
Stocks that are heavily shorted are vulnerable to a short squeeze, which can cause them to go up by many hundreds of percent in a short amount of time. Although you should be able to close your position just fine, these restrictions could cause the stock to go up, and you may need to close your position at a loss. If the short position goes so far in the wrong direction that you don’t meet your margin requirements anymore, then you may be forced out of your position at a big loss due to a margin call. It tends to go up over time, and most individual stocks follow the same trend as the overall market. If this happens, it will cost more to buy back the stock than the cash you received selling it short, so you end up losing money on the trade.
A simple analogy for understanding short selling
Short selling is not a good strategy for inexperienced investors who are unaware of the risks involved in such moves. Say the company has been performing well and currently trades at $200 per share. The investor expects short-term market volatility that might cause a temporary drop in Meta’s stock price but does not want to sell the shares as part of a long-term strategy. To protect the portfolio, the investor short sells shares of Meta as a hedge. If its price drops, the loss in the investor’s long position will be offset by gains in the short position, thus reducing the overall loss in their portfolio.
Margin calls can force you out of your position
For example, in October 2008, Volkswagen briefly became the most valuable publicly traded company in the world during an epic short squeeze. Put options provide a great alternative to short selling by enabling you to profit from a stock price drop without the need for margin. Occasionally, valuations for certain sectors or the market as a whole may reach highly elevated levels amid rampant optimism for the long-term prospects of such sectors or the broad economy. Market professionals call this phase of the investment cycle “priced for perfection,” since investors will invariably be disappointed at some point when their lofty expectations are not met.
The naked short seller may fail to purchase shares within the clearing window, or they may be forced to close their short trade by a margin call before they get ahold of the shares. One of the biggest risks of short selling is a short squeeze, in which a sudden rise in a stock’s price scares away a lot of short sellers at once. Short selling limits maximum gains while potentially exposing the investor to unlimited losses. A stock can only fall to zero, resulting in a 100% loss for a long investor, but there is no limit to how high a stock can theoretically go. A short seller who has not covered their position with a stop-loss buyback order can suffer tremendous losses if the stock price rises instead of falls.
The short seller then returns the shares to the lender and makes a profit by pocketing the difference. It’s a common but controversial way of trading in financial markets. Let’s say an investor decides a company’s share price is overvalued and likely to fall.
This occurs when there’s a price spike in a stock that’s been heavily short sold, which puts pressure on short sellers to close out their positions to minimize losses. In so doing, short sellers buying back the stock help spur further gains in the stock’s price. If a stock is actively shorted with a high short float and days-to-cover ratio (more on that below), it is also at risk of experiencing a short squeeze.
Borrowing the asset comes at a cost, which is normally a small percentage of the asset’s price. However, you can also short-sell using leveraged derivatives, which enable you to speculate on the price movements of an underlying asset without taking ownership of it. As a final thought, an alternative to shorting that limits your downside exposure is to buy a put option on a stock.