How to Short a Stock: Explained

Did you know that you can make money when a company burns to the ground? 🏃‍♂️💨 🔥

Conventional investing wisdom will tell you that you make a profit when the value of a company’s stock rises. But seasoned investors use the strategy of short selling so that they can make a profit even if the stock price of a company keeps falling.

Well this practice can be abused by large and powerful firms through naked short selling, it can also be performed in a more ethically-aligned manner as well.

Short selling is an intriguing concept for many new investors. For most people, it seems closer to gambling than an investment strategy. Anyone who believes that shorting stocks is needlessly risky and certainly a gamble – well, they are not wrong.

Shorting a stock is a popular strategy among experienced investors and traders. It can generate enormous profits, and it can also lead to unprecedented loss. It is a risky plan of action where many a thing can go wrong. ⚠️

If you want to learn about the process of shorting stocks, then you’ve come to the right place. We’ll dive into how shorting works, how you can short a stock, when you should short a stock and when you should avoid it.

Ready? Let’s jump in!

Understanding How Shorting Works 💡

Usually, you invest in a stock because you expect the value of the stock to rise in the future. It’s a fairly simple process – the value of the stock increases, you sell your shares, and then you get to pocket the profits. 

Shorting a stock is a little different from investing in a stock – because short selling works in the complete opposite way. It is a trading strategy where you make money if the price of the stock declines. When you short a stock, you are betting that the stock’s value will fall in the future.

With short selling, the stocks that are being shorted are usually not owned by the party that is selling them. They are “borrowed” and have to be returned to the original seller, eventually. 

Why Shorting Can Be Profitable 💰

Let’s say a trader thinks a particular stock X, which is currently worth $10, is overvalued. So they speculate that the stock’s price will fall in the near future. So, the trader borrows 100 shares of X, then immediately sells them at $10 each and ends up with $1000 in cash. 

Since the stocks are borrowed, the trader has to buy them back and return them to the original owner. If the value of stock X falls to $5, then the trader can buy the 100 stocks they owe for $500 and pockets the other $500 as profit. 

But if the value of stock X rises, then the trader has to take a loss. For example, if stock X’s price goes up to $15 per share, then the trader will have to spend $1500 to restore their borrowed shares, and end up with a net loss of $500. 

The potential for loss with shorting stocks is unlimited. There is no guarantee on how much the value of the stock will be in the future. So even if the value of stock X ends up being $100 per share, the trader has to buy them at the price to return the stocks they borrowed.

An Example of a Shorting 👇

Shorting stocks is a common practice that is used by traders and portfolio managers. It is either used for speculation, or as a hedge against the risk of a long position they have. A recent example can be of Bill Ackman, the billionaire who shorted the market.

In February 2020, Ackman – billionaire and the founder of Pershing Square Capital Management – expressed his worries over the unfolding Covid-19 pandemic. He predicted considerable economic fallout from the pandemic and even contemplated selling all his holdings. 

After publicly announcing that “Hell is Coming” and every industry will be going bankrupt because of the virus, he ended up changing strategies. Instead of selling his holdings, he decided to hedge Pershing Square’s portfolio. This was done to protect the portfolio in case there was a massive sell-off in the market. His decision netted him an enormous profit – that totaled over 2.6 billion. 

Ackman made his profit by buying up credit default swaps and bet against the companies not being able to clear their debt. What he did is an example of using shorting as a hedge to protect one’s investment. Using the profits of the trade, Pershing Square was able to increase its stakes in several major companies at low prices. 

Shorting a Stock in 5 Steps 📉

Short selling is a risky endeavor, but the steps you must follow to short a stock is fairly straightforward:

1. Open a Margin Account ⚠️

If you are interested in shorting a stock, you will need a margin account. A margin account with your broker will allow you to borrow stock as one of your investment options – which will allow you to short stock.

But before you get started, it’s important to note the risks of trading on margin. You could end up with a serious liability, like Bill Hwang who lost $20 billion in two days. Yes, you read that right — $20 billion. 😳

You will need certain permissions before you can operate a margin account, and your brokerage firm will go over the risks that come with short selling. Without a margin account, you cannot short sell – and your brokerage firm may judge you on your suitability before they open such a high-risk account for you.

2. Identify the Stock You Intend to Short ✔️

It is important to have a strategy in place if you intend to short sell. One of the most common strategies is to research overvalued companies. If you think that a particular stock is overvalued and that its value will most likely decrease in the future, then you can consider shorting it. Your due diligence with research can help you with risk management – when a trader does not take the time to research, shorting a stock can lead to their ruin.

3. Contact Your Broker to Execute Your Order ✔️

To short a stock, you will need to borrow the shares from another investor, and then sell them. To borrow shares, you will need to contact your broker and place your order. Your broker will then find another investor who owns the shares and borrow them with the understanding that the shares will be returned to them at a later date. 

If you are borrowing shares, you will have to pay an interest or a fee to the investor you are borrowing from, as well as return their shares at a later date. 

Not all shares can be shorted. For you to borrow a stock, there should be parties that are willing to lend their shares. Usually, the brokers that make shorting stocks the easiest will have a list of shares that can be shorted.

4. Sell Your Borrowed Stock ✔️

If your broker manages to locate the stocks you want to short, and borrows them – you can sell the borrowed stocks in the market, and the proceeds from the sale will be deposited in your margin account. You will need to replace the borrowed stocks at a future date, and will also have to pay an interest to the party you have borrowed the stock from. 

5. Close Out Your Short Position ✔️

You will need to close out your short position on the shares by buying back the shares you borrowed and then sold. If the value of the shares has fallen, then you may make a profit after paying the interest on the borrowed shares and replacing them. If the value of the shares has risen, you will still have to replace the shares and take a loss.

How to Find Stocks to Short 🔎

Before you can sell short, you should know which stocks to target. Researching stocks will help you determine whether a stock is undervalued or overvalued. In order for you to borrow a stock, and then sell it, there should be investors who are willing to lend their shares. 

Usually, good brokerage firms will have a list of stocks that you can short. If you already have a margin account with a broker, then you can ask them to execute your order. 

You can also choose to short a stock that you feel is overvalued by analyzing the news pertaining to stocks, going through patterns and indicators, and creating your own stock watch-list. You will need to be well-versed in reading stock charts and conducting fundamental analysis if you want to make your own predictions—and even then, there is no guarantee that you will be right.

When to Short a Stock 📆

Shorting stocks can make you a lot of money or propel you into unlimited losses. The nature of short selling is tumultuous, but there are several reasons why you should consider shorting: 

The Stock is Overvalued ⚖️

The price of a stock is determined by certain economic principles. A stock is said to be overvalued if its price is not an accurate reflection of its earnings outlook. This comparison of its current price and its earning projection is known as the price-to-earnings ratio, and it is one of the indicators for a stock’s future price—however, even a bad P/E ratio is not a fool-proof way of finding an overvalued stock that’s ripe for shorting. Tesla is a famous example of this. 

If a stock is overvalued, then most likely, its price will fall in the future. This means that if you open a short position on an overvalued stock, you are more likely to make a profit. 

Short Selling Stock to Hedge 📉

Numerous traders and portfolio managers use short selling as a hedge to offset the risk of a long position. A hedge is supposed to neutralize the risks of potential losses that the same investment, or even another companion investment, may incur. 

Using short selling as a hedge involves a much lower risk since it is more about covering your bases rather than speculating about the value of a stock. 

Company is Undergoing Massive Changes 🚧

If you think that a company is failing or about to go bankrupt, then shorting their stock can be profitable. Even if the company is doing well, you will still be able to short their stock as long as it experiences some amount of temporary deterioration. This is mostly because large holders may dump their shares if there has been a decline in the value of the company’s shares. 

When to Avoid Shorting a Stock 🚨

If you are shorting the stock of a company, and its value rises when you need to close out your position, then you will face a net loss. There are certain situations where you must avoid shorting the stock of a company, and they are:

The Stock is Undervalued 💸

If the company offers a product or a service that is essential or has the potential to be a big deal, but its stock prices are low – then it is likely that the company’s stocks are undervalued. In this scenario, you should invest in the company rather than short their stocks. 

The potential for the share price to rise is much greater than the potential for the prices to fall. Some traders and investors are experienced in singling out undervalued stocks and investing large amounts into them. If you decide to short the stock of an undervalued company, then your chances of incurring a loss are far higher.

The Company Might Be a Candidate for a Takeover 🤝

If you hear rumors of a company being acquired by another big business – then you should avoid shorting their stock. It doesn’t matter if the prices of the company’s stock have been showing a downward trend – if it is the candidate for a takeover (either merger or acquisition), then its share prices could skyrocket.

A Renowned Investor is Taking a Position in the Stock 🎯

If a prolific investor or trader is taking an interest in the company’s stock, the chances that the stock is undervalued are pretty high. Moreover, if they make their investment in the company publicly known, there is a chance that more and more people will be buying up the stock. This would mean more demand for the shares and less supply – causing the price of the shares to rise. If you have shorted the stocks of the company, then you will end up incurring massive losses.

There is one piece of financial advice you should always remember – never underestimate the power of social media and memes.  Recently, Elon Musk, the CEO of Tesla and SpaceX, tweeted about a viral children’s song called “Baby Shark”. His tweet boosted the stock price of Samsung Publishing. They happen to be the major shareholder of SmartStudy – who produced the popular song on YouTube.

The Company Has New Developments in Progress 🏗

If the company is involved in a product or a service that has the potential to be groundbreaking, then shorting their stocks is not the safest bet. There is the possibility that their offering could become a big deal, and their stock prices may blow up. Again, shorting their stock could likely lead to a loss. 

There is also the possibility that their product fails and the price of their stock dips. If you had shorted their stock, you could have made a profit. But this scenario is a risky one and if you are new to shorting stocks, then you should steer clear of something that can be very volatile.

The unpredictability of a revolutionary offering is exemplified by the short selling of Tesla’s stock. Before GME and AMC, TSLA used to be short sellers’ biggest target.

Those shorting Tesla stock had marked it for failure because the company had little other than groundbreaking technology to offer. But, between 2017 and 2021, Tesla’s stock value rose 15-fold, and the investors who shorted TSLA stock ended up losing $40.1 billion.

Economic or Political Instability 🏛

The economics of the world is an interconnected web, where economic or political turmoil in one region can affect the whole world. If there are instabilities in certain parts of the world, then shorting stocks is not a risk-free endeavor. 

It can suddenly raise the stock value of a company because of several factors. If the company provides an important service, they will see an increase in their clientele if they can no longer avail the service from elsewhere. The impact of political instability on the stock market in unpredictable, and it should not be used as an accurate metric for determining which stock to short. 

Potential Change in Legislation 👩‍⚖️

Changes in legislation can impact industries positively or negatively. In 2021, the self-regulatory body of Wall Street – Financial Industry Regulatory Authority (FINRA) – proposed certain changes to its requirements regarding the reporting of short-interest. 

The proposed changes are to be made to Rule 4560, which can change the frequency of short-interest reports from twice a month to daily/weekly. If the changes are implemented, then short selling will be under a lot of scrutiny. The proposed changes were prompted by the volatility that short selling of certain stocks, such as GME and AMC, has caused.

If you learn of new legislation about to be passed that might affect a certain industry, you should refrain from shorting their stocks. There is no guarantee that the talks about legislation may go anywhere. Alternatively, the legislation being passed could actually increase the value of the company.

How to Short Penny Stocks 📖

Shorting penny stocks can be risky, as it is with short-selling any stock. Penny stocks are the stocks of small-sized companies that usually trade for less than $5 a share, and most of them are traded via over-the-counter transactions, either through OTP Bulletin Board or the OTC Market group. 

Even without the risk of short selling, dealing with penny stocks comes with significant risks. The companies that issue the stocks have limited resources, no history, and carry enormous risk for fraud. There are no minimum standards that the companies have to adhere to, and that only makes the stock volatile and unstable.

To short penny stocks, the first thing you need to check is if your broker allows it. Some brokerage firms will let you short penny stocks, others won’t. Also, some brokers may not have the shares for you to borrow, but can locate an investor with the stock you want. 

The process of short selling is the same as the process of short selling any other stock. This means that shorting them will carry the same risks, with the added disadvantage of volatility and the possibility of the company going bankrupt overnight.

How Can I Short a Stock With Options? 📅

There are some marked differences between regular short selling and shorting a stock with options. If you are shorting stock using options, then you will have a limited time on your short position after which your option will expire. 

With the expiry of the option, you will need to close out your short position or fulfill the obligations that the options contract has. Because of this, shorting a stock using options is better for traders who believe that the downward trends of the market are temporary. 

If you want to short a stock with options, then there are certain strategies you can adopt:

Put Options ✔️

With short selling, you are obligated to buy back the shares no matter what the current price of the share might be. Put options are a less risky alternative to short selling.

With a put option, you can sell the stock at the strike price (the set price at which the option can be bought or sold) before the expiration. You can turn a profit with a put option either when the value of the stock decreases, or when the market turns volatile. 

Covered Put ✔️

A covered put is a trading strategy where you short a certain number of shares, and then sell a put option for the same amount of shares. A covered put will offset your market position, and you will generate profits through the premium you will get for writing the put option.

Synthetic Short ✔️

The synthetic short is an options strategy that combines two options positions – buying a put option and selling a call option at the same strike price, and having the same expiration. If the value of the stock declines, then your put option will net you a profit. If the value of the stock increases, so will the value of your call position.

Call Options ✔️

With a call option, you turn a profit through the premium that you receive for writing the option, provided that the value of the stock does not jump by a lot.

This is a very risky strategy because the profit is limited to the premiums, but the loss can be unlimited. Unlike using a put option, shorting with a call option is more similar to shorting stocks directly because you are buying the stock you want to short and can suffer great losses if the stock performs unexpectedly well.

Why Short Stocks? ⭐️

Shorting a stock could net you a huge profit, which is why traders and portfolio managers use it as an effective strategy. If you are an experienced trader, and are certain that the value of a stock will fall in the future, shorting the stock could mean a guaranteed profit.

If you are shorting a stock, then you are borrowing shares with an obligation to return them at a later date. This means you do not need to put up a lot of money upfront and can still make a huge return. Shorting a stock will allow you more leverage since you only need to put up a small percentage of the actual value of the stocks you are short selling. It also allows you to make money in a bear market when your stocks will dip in value. 

Shorting is also an effective way to hedge your investments. If a share you own lost some value, and you feel that its price may go down even further sometime in the future, then you can short the stock and can turn a profit if the value does take a downturn.

Drawbacks of Shorting Stocks ⚠️

Now let’s talk about cons. With short selling, the profit potential may be immense, but the potential for loss is limitless. A real life case of how shorting can lead to huge losses is that of the investors who shorted AMC stock, and ended up losing $1.23 billion. AMC was a heavily shorted stock whose value jumped up a lot in a short amount of time. 

In January 2021, the stock rose from $5 a share to $20 a share, and at its peak, its value was $36.72 a share. This forced the short sellers to buy back the borrowed stocks, and close out their short position, at a heavy loss.

AMC is considered to be a ‘meme’ stock – whose value rose because retail investors decided to take a stand against the hedge funds that sought to profit by bankrupting a company they saw value in. Currently, retail investors own about 80% of AMC’s outstanding shares. 

If you have shorted a stock, then you will need to close out your position at some point. You may run into trouble trying to find shares to buy, and may not be able to cover your shorts. You may also get yourself caught in a short squeeze – because of the needed shares being unavailable, the demand far exceeds the supply, and the price skyrockets.  

The Good and the Bad with Shorting Stocks

How to Avoid the Risks of Shorting Stocks ✅

Short selling comes with its own set of risks. To minimize your risks, remember the following points:

Be Careful When Shorting – it Uses Borrowed Money 💸

Short selling requires a margin account – which means that you borrow money from the brokerage firm you are using, and your investment portfolio is your collateral. If you incur too many losses, you will receive a margin call. This means that you either have to put in more money or sell your investments to pay off your losses.

Get Your Timing Right ⏱

Even if your speculation about an overvalued stock is correct, it can take a while for the stock to decline in price. If you had shorted a stock using options, then you may be at the risk of a loss. Even if you have shorted the stock in the regular way, you will still have to pay the interest on the borrowed. You must get your timing right. If the stock has not shown an affinity towards a downturn, weigh your choices before shorting.

Learn More About Short Selling 🎓

Usually, short selling is only recommended for those traders who have considerable experience. It is a very risky endeavor, and several things can go wrong. If you are interested in short selling, you should make it a point to learn all that you can about it. Your knowledge may help you immensely.

Conclusion 🏁

If you’ve come this far – well, now you know the important aspects of shorting stocks. Shorting stocks comes with considerable risks, which is why the more experienced of investors attempt it. If you are a newbie and are interested in short selling stocks – then you need to learn all that you can about it. 

Before you short a stock, you will need to do your research about the value of the stock to avoid any unnecessary risk. You will also need a margin account with your broker if you intend to short sell. It is important to remember that the stock you short are ‘borrowed’, and have to be returned. You will also need to pay an interest on the borrowed stock, so take that factor into consideration.

Shorting a stock could lead to an enormous profit, or to a loss that can ruin you. It is an effective investment or hedging strategy for those who know what they are doing. If you are a risk-taker and want to dip your toes into the more advanced strategies of trading – then you can consider shorting stocks for profit.

Get Started with a Stock Broker