Short Selling Guide: How to Short a Stock
How Can Short Selling Make Money?
One way to make money on stocks for which the price is falling is called short selling (also known as "going short" or "shorting"). Short selling sounds like a fairly simple concept in theory—an investor borrows a stock, sells the stock, and then buys the stock back to return it to the lender. In practical terms, however, it is an advanced strategy that only experienced investors and traders should use.
Short sellers are wagering that the stock they are short selling will drop in price. If the stock does drop after selling, the short seller buys it back at a lower price and returns it to the lender. The difference between the sell price and the buy price is the short seller's profit.
Example of a Short Sale
For example, suppose an investor thinks that Meta Platforms Inc. (FB), formerly Facebook, is overvalued at $200 per share and will decline in price. In that case, the investor could "borrow" 10 shares of Meta from their broker and then sell the shares for the current market price of $200. If the stock goes down to $125, the investor could buy the 10 shares back at this price, return the borrowed shares to their broker, and net $750 ($2,000 - $1,250). However, if Meta's share price rises to $250, the investor would lose $500 ($2,000 - $2,500).
What Are the Risks?
Short selling substantially amplifies risk. When an investor buys a stock (or goes long), they stand to lose only the money that they have invested. Thus, if the investor bought one FB share at $200, the maximum they could lose is $200 because the stock cannot drop to less than $0. In other words, the lowest value that any stock can fall to is $0.
However, when investors short sell, they can theoretically lose an infinite amount of money because a stock's price can keep rising forever. As in the example above, if an investor had a short position in Meta (or short sold it), and the price rose to $375 before the investor exited, they would lose $175 per share.
Another risk faced by short sellers is that of a "short squeeze," in which a stock with a large short interest (i.e., a stock that has been heavily sold short) climbs rapidly in price. This triggers a steeper price ascent in the stock as more and more short sellers buy back the stock to close out their short positions and cap their losses.
In January 2021, followers of a popular Reddit page called WallStreetBets banded together to cause a massive short squeeze in stocks of struggling companies with very high short interest, such as video game retailer GameStop Corp. (GME). This caused the company's share prices to soar 17-fold in January alone.1
Short selling can generally only be undertaken in a margin account, a type of account by which brokerages lend funds to investors and traders for trading securities. Therefore, the short seller has to monitor the margin account closely to ensure that the account always has sufficient capital or margin to maintain the short position.
If the stock that the trader has sold short suddenly spikes in price (for example, if the company announces in its quarterly report that earnings have exceeded expectations), the trader will have to pump additional funds into the margin account right away, or else the brokerage may forcibly close out the short position and saddle the trader with the loss.