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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.
Disclaimer: Short selling is for advanced traders. The value of any investment can go up or down depending on news, trends, market conditions and other factors. You may lose more money than you invested. We are not investment advisers, so do your own due diligence and consult with financial professionals before investing to make sure you 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 decreased, 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 sustain the losses). 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.
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.
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