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How to short a stock
Short selling is a risky investment strategy where you make money off of stocks that you expect will decrease in value.
There are a few different ways to short sell a stock, from borrowing shares from a broker to less traditional options like spread betting. Find out what short selling means, how to do it and the risks involved.
Disclaimer: Short selling is for advanced traders. Investments can change in value depending on many factors, and you may lose money. We are not investment advisers, so do your own research and consult with professional investment advisors to fully understand your options and the risks involved.
What is short selling?
The idea behind this investment strategy is that if you think a stock’s value is going to decrease, you can make money out of it. You borrow the stock from a broker, sell it at the market price, buy it back when the price has gone down, then give the stock back to its legitimate owner and keep the profit.
A quick example. Say you think Canadian Tire’s stock prices are going to fall today. You borrow 10 Canadian Tire shares that cost $90.00 each and sell them at market price ($90.00 x 10 = $900.00). It turns out you’re right and, by the end of the day, each stock is only worth $75.00. You buy the stocks back for less than you sold them ($75.00 x 10 = $750.00), then give them back to the broker. You keep the profit, which is $900.00 – $750.00 = $150.00. Even after the fee, you’ll have to pay to your broker for the stocks you borrowed, it’s still a nice earning.
Sounds easy, but the problem is, things could also go the other way around. If it turns out that you were wrong, and at the end of the day 1 Canadian Tire share is worth $100.00 instead, you’ll have lost ($100.00 x 10) – $900.00 = $100.00.
Step-by-step guide to short sell a stock
These are the basic steps:
- Find a broker from whom you can borrow the stock. Not all brokers will facilitate short selling and not all stocks will be available for borrowing (it may even be impossible), so you may have to do some research.
- Open a position to sell it. It will be bought at the market price.
- Keep an eye on the price. Getting distracted is a bad idea. You need to be able to react quickly if things go wrong.
- Buy the stock back when you think it’s the right moment. You’ll need to find a good risk/reward balance. When things are going well, it’s easy to become too greedy and wait too long to buy back.
- Give the stock back and keep the profit (or cover the loss). If the price goes down and you buy back for less, you’ll have made money out of your short selling. If the price goes up, you’ll lose money instead. Don’t forget that the risk is all on you.
Example of short selling
Let’s say you believe the latest Disney movie won’t be well received and that Disney stock will subsequently go down from its (hypothetical) current price of US$150.
You contact your broker and ask to borrow, say, 10 Disney stocks. The broker agrees and obtains the stocks, either from his or her own account, another investment firm or the account of another client.
You open a sell position for 10 Disney stocks. This means you declare that you’re willing to sell 10 Disney stocks at the current market price. A willing buyer connects with your broker and buys the stock at the current market price of $150 X 10 = $1,500. Because you don’t actually own the stocks, you’re now “short” 10 Disney stocks—but you have $1,500 in your pocket.
You think the stock value will go down by at least $15 but aren’t confident that it will go down more. Therefore, you set a stop-loss order for US$130 ($150 minus $15 equals $135). This means that you tell your broker to buy back the stock if the price dips below $135. Alternatively, if you’re not sure how much the price will go down, you could simply monitor the price yourself and buy back the stock when it changes, without a stop-loss order.
One of 2 things will happen:
- The stock price goes down. You’re right! The price of Disney stock goes down to $130, at which point you take $1,300 of your $1,500 to buy 10 Disney stocks. You return all the stocks to your broker and pocket the remaining $200.
- The stock price goes up. Sadly, you’re wrong. The price of Disney stock goes up to $160. You’re obligated to buy back the stock and return it to your broker. You pay $1,600 to buy 10 Disney stocks ($1,500 comes from the money you made from selling the stock in the first place, and $100 come from your own pocket). You return all the stocks to your broker and absorb the $100 loss.
Why would brokers lend stocks to clients? What do they get out of the deal?
Brokerages let clients open a margin account when they have several thousand dollars or more to put up front. A margin account essentially gives clients a line of credit from which they can borrow funds to invest.
Typical margin account agreements allow brokers to lend out any of the client’s securities. Brokers charge interest on the stocks they lend you. This fee comes out of the profit you earn from short selling (or out of your pocket if you suffer a loss).
If the client wants to sell their stock before it’s returned, the broker replenishes it from the brokerage’s account.
What costs are involved?
To short sell, you usually need to trade on margin, which means that you’re borrowing funds to buy stocks that you intend to sell and rebuy later. You may need to pay interest on the value of the borrowed stocks while you’ve got a position open and are waiting for a buyer.
Sometimes, it might be difficult to get hold of stocks to borrow. There may be a fee for getting a hold of stocks in the first place.
Like margin interest, you may be responsible for covering the dividend payments your lender would have received on the stock you borrowed.
What are the perfect conditions for short selling?
As with watersports, winter sports and growing plants, there’s an ideal condition for short selling stocks. Stocks go down quicker than they go up. This means that you want to borrow and sell stocks before the price goes down and buy back the stocks just before the price rebounds.
The ideal condition for short selling is a bear market.
A bear market exists when stocks are generally declining in value–usually by more than 20%. For example, a bear market existed right at the start of the pandemic, when the economy took a nose dive and businesses were suffering. For short sellers, this was an ideal time to be shorting stocks.
Non-traditional short selling
Borrowing shares from a broker isn’t the only way to short a stock. You can also use:
- Derivatives. Derivatives allow you to speculate on prices without actually owning the shares. You can short sell through spread betting and CFD trading, but be aware that they’re extremely complex and risky financial instruments. Most investors lose money when trading this way.
- Option trading. This is (only slightly) less risky than traditional short selling. You can purchase an option on a stock that allows you to sell it at the initial market price within the option’s expiry date. If the price goes down, you sell, buy back at the new price and make a profit. If the price goes up, you don’t sell at all and only lose the value of the option, thus limiting the risk. With traditional short selling, you can buy back whenever you want (unless the owner of the stock claims it back), whereas options normally have a fairly short expiry date.
Risks of short selling a stock
Repeat after us: short selling is for expert investors and you shouldn’t do it unless you do know what you’re doing.
The reason why it’s considered very risky is that it could make you lose “infinite” money. When you buy a share and “go long”(expect to profit by an increase in price) the maximum you can lose is the amount you invested.
When you sell a share and “go short” (expect to profit by an decrease in price), there are theoretically no limits to how much share prices could go up, and thus to how much you could lose. Not good.
It’s especially dangerous if a lot of people are short selling shares from the same company and the price unexpectedly goes up. At that point, everyone will start buying back really quickly, causing the stock to go up even more. It’s what’s called a “short squeeze” and it easily becomes a vicious circle that turns out very expensive for short sellers.
Finally, don’t forget that short selling isn’t free. Brokers will charge a fee for lending the stocks, and there are fees for other short selling methods too. Be aware that these will partially lower your gains and increase your losses.
Compare online trading platforms that support short selling stocks
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