Short selling gets a bad rap in the investment world because traders benefit from a company’s loss. It’s also considered high risk. That’s because you lose money if the stock price rises, and theoretically, there’s no limit to how high a stock price can go. There are a few different ways to short-sell stocks — and various risks are involved.
What is short selling?
Short selling is an advanced trading strategy that aims to benefit from falling prices. Typically you need to have a margin account — an account where you can borrow money from your broker — to short a stock directly.
Short selling works by borrowing shares from your broker and immediately selling them on the market. Once the share price drops, you buy back the shares cheaper and return them to the broker. You pocket the price difference.
A short selling example
Let’s say you have your eyes on Nvidia (NVDA), a graphics card manufacturer. Nvidia thrived during the covid lockdowns as more people stayed at home and bought computers. It also benefited from the rising prices in crypto because Nvidia’s graphic cards are used for cryptocurrency mining.
But now things have changed. Workers are back in the office, and cryptocurrencies are frozen in a prolonged crypto winter. Add in high interest rates and a potential recession, and Nvidia’s shares may continue to drop.
Here’s how you would benefit from it by short selling its stock.
You borrow 100 NVDA stocks from your broker.
Sell them at market prices, say $200 apiece for a $20,000 total.
Keep the $20,000 in your account and wait.
NVDA stock price is down to $100 now.
Pay $10,000 to buy back the 100 stocks at $100 and return them to your broker.
Keep the $10,000 profit ($20,000 – $10,000 = $10,000).
Note: This is an ideal scenario where the price drops. If you’re wrong and the price goes to $300 per stock, you would have to pay $30,000 to buy back 100 stocks. In this case, you would lose $10,000 ($20,000 – $30,000 = -$10,000).
How to sell a stock short
The traditional means of shorting a stock directly is to do it via a full-service broker like Interactive Brokers or a major investment fund such as Morgan Stanley. Modern online brokerage accounts have made it easy to short a stock by selecting it as the order type. Here is the general process for shorting a stock:
Find a broker or brokerage account that offers short selling. Not all brokers will facilitate short selling and not all stocks are available for borrowing, so you may have to do some research.
Enter the order. Choose a market or limit order, the number of stocks and any other details. The stocks sold short are held under a contractual lending arrangement, which may require a stock loan fee. Your brokerage could also require you to have a margin account, or cash collateral equal to an additional percentage of the stock price to protect you if the trade goes against you.
Buy the stock back at the right moment. Find a good risk and reward balance. When things are going well, it’s easy to become too greedy and wait too long to buy back.
Return the stock and keep the profit — or sustain the loss. The risk falls back on you. If the stock price falls, you make money — and you lose money if the price increases.
Benefits of shorting a stock
Profit from the drop. You’ve used technical and fundamental analysis to determine that a certain stock’s price is likely to drop. After careful analysis of a company, you have good reason to believe it will undergo a negative event or has already gone through one, which will cause its stock price to fall.
Hedge against a long position. When taking a long position, you hold onto a stock with hopes that its price will rise before you sell. If it doesn’t, your short selling profits may make up for these losses.
Provides liquidity. By selling stocks on the market, you provide liquidity to the buyers.
Helps avoid bad companies. Some funds provide short-seller research reports on fraudulent companies, which helps investors avoid these businesses.
Risks of short selling
Losses can be unlimited. When you buy a stock, the maximum you can lose is the amount you invested. When you short a stock, there are theoretically no limits to how much the stock price could go up, and thus to how much you could lose.
Higher risk. What makes this especially dangerous is if a lot of people are short selling stocks from the same company, and the price unexpectedly goes up. At that point, everyone will start buying back quickly, causing the stock to go up even more. It’s what’s called a “short squeeze,” and it easily becomes a vicious cycle that turns out very expensive for short sellers.
Additional costs. Since you’re borrowing stocks, typically, you have to pay a fee for that. The harder the stock is to borrow — meaning a lot of people are already shorting it — the higher the fee.
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Costs of short selling stocks
Aside from the risk of losses, short sellers have to pay fees.
Margin loans. To directly short a stock, you need a margin account. This means you’re borrowing money from the broker. The broker typically charges a rate for margin loans, anywhere from 0% to 10% annually.
Cost of borrowing. Short sellers are often required to pay a fee for stocks they borrow. The cost typically depends on how hard is to borrow a certain stock. The harder to borrow, the higher the cost.
Dividends. If the stock you short pays dividends, you must cover the amount paid during the time you shorted the stock.
Is short selling legal in Canada?
Yes, short selling is legal in Canadian financial markets. While some countries in Europe and Asia have temporarily banned short selling of certain assets during times of financial crisis, like in 2008 and 2020, it’s still legal in Canada. Short selling is often misunderstood and sometimes blamed for market crashes, though its actual role in a market crash has been studied and debated, with some economists concluding that it plays an important role in the process of price discovery.
Other ways to profit from a falling stock price
As financial markets have developed, new ways of achieving the same goal as short selling have been introduced. Consider how each one might help you achieve your investing goals.
1. Buy a put option
The most popular alternative to shorting a stock is to buy a put option on it. Put options allow traders to pay a small percentage of the stock price, called a premium, for the option to sell the stock at the stated strike price at the predefined future date. This date can ranges from a week or month to several months or years.
If the stock price has fallen when that date arrives, you can exercise the option and profit on the difference between the lower market price and the option strike price, minus the cost of the premium. Or you can sell back the option at the market price at any time before it expires.
If the stock price has risen, however, the option expires worthless on its expiration day and you lose the premium you paid.
2. Sell a call option
If you already own shares in a company that you think will suffer a drop in stock price, you can sell a call option that earns you the premium paid by the buyer. This offsets some or all of your losses, but it obligates you to sell your shares at the strike price on expiration day if the trade goes against you and the stock price continues to rise.
Or you can speculate and sell a call option without owning the stocks. This is called selling a naked call or naked call writing. Your broker will likely require you to have a margin account or receive special authorization to sell naked calls prior to trading. This strategy assumes that you’ll buy back the call option in the future or buy the stocks at a future market price before expiration day to exercise the option.
3. For select indexes or themes, buy an inverse ETF
Inverse ETFs are a relatively new investment that aims to gain when the underlying asset price declines. They exist as a complement to regular ETFs on popular indexes like the S&P 500, Dow Jones Industrial Average and Nasdaq 100, as well as market sector ETFs and leveraged ETFs.
Buying an inverse ETF achieves the same goal as shorting the ETF, but without some of the risks.
Leveraged ETFs, whether they’re inverse or not, are designed for short-term trades only and should not be bought and held. Leveraged ETFs are rebalanced daily, and sustained ups and downs during volatile periods will erode the asset base and degree of exposure of the ETF. This means that its ability to rebound after each loss is diminished over time.
4. What about CFDs?
In some countries, contracts for difference (CFDs) allow you to speculate on stock prices without actually owning the stocks, meaning you could bet on a decline in a stock price similarly to selling it short. CFDs are legal in Canada but not in the US.
Bottom line
Short selling lets you earn a profit with falling stock prices.
The risks are often higher than buying stocks.
Short selling comes with additional fees and costs that you have to pay to your brokerage account and platform. Make sure you sign up with a broker that offers short selling, as not all of them do.
Frequently asked questions
The actual stocks that you can short sell are typically determined by the brokerage and are influenced by trading volume, so stocks of larger companies are more likely to be available for shorting. Check on any stocks you're considering shorting within your brokerage account.
The market keeps track of stocks that are sold short through a measure called short interest. You can look up a stock's short interest in your brokerage account or on other market data websites.
Yes, you can sell short stocks that you own to protect your portfolio from a drop in price and avoid creating a taxable event. This is known as a short sell against the box and is a strategy utilized by long-term investors.
This depends on your risk profile. You can short a stock by buying inverse exchange-traded funds (ETFs), or you can directly short a stock via brokerage platforms. This means you would have to borrow the shares you want to short from the brokerage and sell them on the market.
Shorting shares directly comes with additional fees and costs as opposed to inverse ETFs where you only pay either a small annual fee or no fee at all depending on the ETF.
Disclaimer: This information should not be interpreted as an endorsement of futures, stocks, ETFs, options or any specific provider, service or offering. It should not be relied upon as investment advice or construed as providing recommendations of any kind. Futures, stocks, ETFs and options trading involves substantial risk of loss and therefore are not appropriate for all investors. Trading forex on leverage comes with a higher risk of losing money rapidly. Past performance is not an indication of future results. Consider your own circumstances, and obtain your own advice, before making any trades.
Kliment Dukovski is a personal finance writer at Finder, specializing in investments and cryptocurrency. He's written more than 700 articles to help readers compare the best trading platforms, understand complex investment terms and find the best credit cards for their needs. His expert commentary has been featured in such digital publications as Fox Business, MSN Money and MediaFeed. He’s also well-versed in money transfers, home loans and more — breaking down these topics into simple concepts anyone can understand. In another life, Kliment ghostwrote guides and articles on foreign exchange, stock market trading and cryptocurrencies.
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