Complete Guide to Short Selling

Have Tesla (TSLA) short sellers caught your attention?

Not too long ago, they caught the attention of many. One week after Tesla stock hit an all time high, tech stocks started to plummet, leaving short sellers grinning from ear to ear.

But it wasn’t so simple – tech stocks were soon after on a rollercoaster, and continued to see turbulence for quite some time. The whole saga demonstrates the inherent risk in short selling.

So, what exactly happened? 🤔

Well, short selling can be used in two ways. The first is to mitigate risk and protect gains, and the second is to profit off a declining market.

In the case referenced above, investors were aiming for the latter: they borrowed stock to sell at the current market price (usually because they think it is overvalued). The bet being, the stock or asset would later fall in price, thus allowing investors to buy it back for less.

This strategy has the potential to generate significant profit. However, it also leaves investors vulnerable to a plethora of heavy risks.

It can be a costly game for some, and investors should have a strong understanding of what the ideal shorting environments are before they even consider it. Still interested?

In this guide, we will go through exactly how short sellers make money, how to recognize the ideal shorting environments, and the serious risks involved. 

What is Short Selling?

Short selling is a strategy used by speculators to essentially bet that a particular stock or some other type of security will drop in price in the future. This strategy is particularly difficult (although the concept is simple) and is generally only undertaken by traders and investors with solid experience.

While some traders use short selling as speculation, portfolio managers or investors might use it to hedge against the downside risk of a market decline in the same market or related one.

As a whole, speculation is quite risky and is an advanced strategy. Hedging involves more common transactions that place an offsetting position to lower the risk of exposure.

When it comes to short selling, traders open a position by borrowing shares of a stock or other assets with the hope that it will decrease in value in the future/ by the expiration date.

The investor will then sell the shares and buy them back for less when/if they decline in price. This involves unlimited risk because, in theory, stock or any other asset can keep rising to infinity.

How Does Short Selling Work?

Short sellers open a position by borrowing stock, generally from a broker, to sell and buy back at a date in the future for less. 

For example, if you believe that Tesla (TSLA) stock is overvalued at $419.62, you could borrow some TSLA shares from your broker and then sell them for the current market price of $419.62. Later, if the stock declines you can buy the shares back and earn a profit. In order to do this effectively, you should consider one of the leading brokers for short selling stocks.

To open a short position, you will need a margin account, and you will usually be charged commission on the shares you borrow while the position is open. 

How Much Money Do I Need to Short Sell? 💰

Opening a margin account requires investors to maintain a minimum balance which is enforced by the Financial Industry Regulatory Authority. Inc (FINRA), the governing authority. It’s important to note that if your account falls below this you will need to fund the account or the broker might sell the position.

To close a position, you will need to buy back the shares you borrowed – hopefully for less than you sold them for – and return them to the lender. You will need to account for the brokers fees and commissions on the trades, too.

In addition, each broker will have its own qualifications that the trading account will need to meet before margin trading is permitted.

How Do You Make Money Short Selling Stocks? 💸

Short selling can be used for speculation or hedging purposes. Speculators aim to use short selling to capitalize on the price decline in a stock or security. Hedgers, on the other hand, use short selling to mitigate against risk in a portfolio or security.

Notably, more savvy investors and institutional investors often engage in hedging and speculating at the same time.

While short selling presents the potential for investors to generate profit in a declining or neutral market, it should only be considered by more advanced traders because of the significant risk involved.

Short Selling vs. Put Options

As a whole, short selling is riskier than buying put options. Shorting can carry less risk when the security is an ETF or index. Short selling is also more expensive and can accrue more fees than buying puts due to the margin requirements.

If you’re interested in options trading, consider our options trading guide, where we break down options for anyone to understand and discuss the key difference between US and EU options.

Pros and Cons of Short Selling

Below we have summarized some of the primary advantages and disadvantages of short selling:

When it comes to closing a position, short sellers might run into some trouble trying to find potential shares to buy – when a lot of traders are shorting or if it’s thinly traded. Conversely, short sellers might end up sandwiched in a short squeeze if a stock, or market skyrockets. There’s also the potential for the phenomenon of a gamma squeeze, the short squeeze’s cousin, to arise as well.

Tech stocks in particular, have been on a rollercoaster since Tesla (TSLA) and Apple (APPL) announced their stock splits on August 31st. Tesla stock hit an all time high on September 1st leaving short sellers breathing a sigh of relief. However, just one week late the stock plummeted, and is now amid a tech stock rebound.

Tesla has the single largest short position of any U.S. stock, according to S3 Partners. And while short sellers rack their brains over how far detached the stock is from reality, Tesla is an example of the serious risks involved in short-selling.

Risks to Short Selling

❌ Uses borrowed money 

❌ Bad timing 

❌ Shaky regulatory sector

❌ The short squeeze

Aside from the risk of losing money on a rising stock price, short selling has some additional risks that anyone looking to short sell should consider.

Short Selling Uses Borrowed Money 🤝

To start, short sellers use borrowed money. To start short sellers you will need to open a margin account, which allows you to borrow a percentage of the trade from the broker.

This makes it easy for losses to get out of control because you must have a minimum balance of 25% of the trade at all times. If you fail to meet the minimum balance the broker could send a margin call, which is a demand to fund your account, or your position could be liquidated.

Bad Timing ⏰

Another disadvantage is that even though the company might be overvalued, it could be a while before the price actually declines. During this time you will be paying interest, and your account might fall below the minimum balance.

To help you stay on top of all the current trends and get the timing of your trades right, we’ve reviewed and numbered the best performing stock trading apps on the market.

Shaky Regulatory Sector 🕵️‍♀️

There’s also the risk that short sales might be banned in a specific sector or sometimes in broader markets to avoid pressure to sell. This can cause stock market prices to spike, forcing the short seller to account for huge losses.

The Short Squeeze & Buy-ins ⚠️

One of the biggest risks of all is short-selling is a short squeeze. Short squeezes happen when a stock price rises high enough to alert short sellers to start closing out their positions. To close a position, the short sellers start buying back shares. This can cause a feedback loop. 

The high demand attracts more buyers, which triggers investors to cover themselves, ultimately pushing the stock up exponentially in a short period. 

This results in heavy losses for some short sellers. Most brokers enforce safety measures called buy-ins to help protect investors from losses too large or out-of-control. 

Betting Against the Grain 🎲

Historical data shows that, in general, stocks drift upwards. In the long term, the majority of stocks appreciate in price. For that matter, even when company’s hardly improve in the long term, the sheer effects of inflation and the rates of economic price increases drives stocks up. This means that shorting stocks is a bet against the natural movement of the market.

Short selling, like any industry, is susceptible to fraudulent practices. Recently, Nikola’s electric truck company has been accused of “intricate fraud” and of perpetuating “numerous lies”.

Short Selling Costs & Fees

While buying and holding investment don’t accrue too many costs, short selling results in some hefty ones, on top of the typical trading commissions charged by brokers. Here’s a quick run-through of some of the costs:

If you choose to go with stocks, there are a number of brokers that offer free stock trading. Not all offer the same features, so make sure to research each option carefully.

Short Selling Metrics

There are two metrics to track the short-selling activity on a stock—these are the “short interest ratio” and the “short interest-to-volume ratio.” Here is how they work.

The short interest ratio, a.k.a. “short float,” measures the ratio of shares that are shorted in comparison to the amount of shares that are “floating” in the market. Note that it is possible that there are more shorted shares of one stock than there are shares in existence.

For example, GME stock was 138% shorted when investors started buying like crazy, and short-sellers had to pay a fortune to buy back the now-pumped stock. A high SIR or short float might mean that the public faith in a stock is low and that you ought to join the pessimistic bandwagon—but it might also make a stock susceptible to a short squeeze, which can be extremely dangerous for short-sellers.

The other crucial metric we mentioned is the short interest-to-volume ratio. Also called the “days to cover ratio,” it divides the total shares held short by the average daily trading volume of the stock. A high value of this ratio is a bearish indication for a stock.

Short Selling Conditions

Timing is key with short selling. In general, stocks decline a lot quicker than they advance, and a potential sizeable gain could be wiped out in a matter of days on a bearish development. A short trade, therefore, must be timed to perfection.

Here are some key signs to look out for to improve your chances of success:

During a Bear Market 🐻

Remember we said when you are essentially betting against the natural trend of the stock market when you short stock? Well, the typical rules don’t apply in a bear market – it’s all fair game.

This is the ideal environment for short sellers. Short sellers flourish in broad, swift, and deep market declines because windfall profits are up for grabs – like during the global bear market in 2008-2009.

Deteriorating Market Fundamentals ⬇️

The fundamentals of a stock deteriorates for a multitude of reasons including rising input costs, slower profit growth, and challenges the business is facing.

More experience might think it wise to wait until the trend is confirmed before going short, rather than solely anticipating the trend. To better understand how fundamentals can impact stock price, we created a complete guide to factor investing.

Technical Indicators of a Bearish Trend 📉

Look for technical indicators that confirm the bearish trend. Indicators might include a bearish moving average crossover like the “death cross.”

An example of this is when a stock’s 50-day moving average drops lower than its 200-day moving average. A moving average is just the average stock price over a particular period of time.

Short Selling Reputation

Short selling is often criticized, and short sellers are called ruthless destroyers of companies. One staunch believer of this is Space X CEO, Elon Musk.

In December 2019, Musk targeted short-sellers once again in a Tweet, after reports circulated that Japan’s Government Pension Investment Fund, the biggest pension fund in the world, would no longer be lending shares from its $370 billion equity portfolio.

In response he wrote, “Bravo, right thing to do! Short selling should be illegal.” In the past, Musk has called short sellers “jerks who want us to die.”

Is Short Selling Really That Bad? 📉

In reality, short selling creates liquidity, as in it provides enough buyers and sellers to markets, and can help prevent stocks becoming overvalued. We can see the evidence of its benefits in asset bubbles that disrupt the market. 

An asset bubble can be described as the fast escalation of market value, particularly in the price of assets. The rapid inflation is followed by a sharp fall in value, sometimes called a “crash”, or “bubble burst.”

Real-World Example of Short Selling 🎯

A short squeeze can be triggered by unexpected news events which may cause short sellers to buy at whatever the market price is to cover their minimum margin requirements. For example, Volkswagen was briefly the most valuable publicly traded company in the world during a short squeeze in October 2008.

This year, it was reported that Porsche was attempting to gain majority control of Volkswagen. It was expected that once Porsche was in control, its stock market value would decline, so short sellers began heavily shorting the stock.

However, much to everyone’s surprise, Porsche announced that it had acquired over 70% of the company using derivatives. This triggered a huge feedback loop of short sellers buying back their shares before they got more expensive.

This left short sellers at a disadvantage because a government entity owned 25% of Volkswagen, and it wasn’t interested in selling stock. Porsche owned another 70%, leaving only a small amount of shares floating on the market. 

Essentially, the interest on the short and the days to cover ratio skyrocketed in one night, causing the stock to explode from just €200 to more than €1,000.

Short squeezes generally fade quickly though, and after just a few months, Volkswagen stock had regained its usual market position.

Get Started with a Stock Broker

Shorting is a serious procedure and requires a reputable broker with all the tools a pro trader might need—plus, you want all important shorting metrics available to you at a click of a button.

Here are a few popular choices for short-sellers who want all of that and more: