Short selling gets a bad rap in the investment world because traders are benefiting from a company’s loss. However, you can use this strategy to offset your own losses during a stock market crash. This can be particularly useful for investors holding a portfolio of dividend shares that they’d prefer not to sell as prices fall.
While it varies from country to country, there are a few different ways to short sell stocks — and there are risks involved.
The idea behind this investment strategy is that if you think a stock’s value will decrease, you can make a profit. You do this by borrowing a stock from a broker and selling it at the market price. Once the price decreases, buy it back and return it to the legitimate owner — and pocket the profit.
Crunching the numbers: How short selling works
Here’s an example of a short sale profit when you think MSFT stock price will fall.
Borrow 10 MSFT shares that cost $175 each and sell them at market price. $175 x 10 = $1,750
If you’re right, and the stocks are worth $165 each by the end of the day, buy them back for less than you sold them, and return them to the broker. $165 x 10 = $1,650
You keep the profit. $1,750–$1,650 = $100
Even after a potential broker fee, it’s a nice profit.
The risk comes if things don’t go your way.
If you’re wrong and 1 MSFT share is worth $185 instead. $185 x 10 = $1,850
You’ll lose money. $1,750–$1,850 = -$100
Is short selling legal in the US?
Yes, short selling is legal in American 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 the US.
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.
Naked short selling is illegal
As with many other areas of the stock market, short selling can become complex in some situations, and the practice of naked short selling is against the law. Naked short selling is when a stock broker or dealer borrows a share to sell without verifying that the share actually exists or legally belongs to the entity it’s borrowing from.
It is illegal to borrow a stock to be shorted and then not deliver it when it’s time to buy back. There’s concern that naked short selling has become a problem in today’s markets.
How to sell a stock short
The traditional means of shorting a stock directly is to contact a full-service broker or a major investment fund such as Morgan Stanley. Full-service brokers usually offer advice alongside trading — and they charge a premium price for the service.
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 shares and any other details. The shares 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.
Keep an eye on the price. Watching the prices help you react quickly if things go wrong.
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.
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.
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.
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 shares. 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 making the trade. This strategy assumes that you’ll buy back the call option in the future or buy the shares at a future market price before expiration day to exercise the option.
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.
What about CFDs?
In some countries, contracts for difference (CFDs) allow you to speculate on stock prices without actually owning the shares, meaning you could bet on a decline in a stock price similarly to selling it short. However, CFDs are not allowed in the US.
Risks of short selling
Short selling is for experienced investors and you shouldn’t do it unless you know what you’re doing.
The reason it’s considered so risky is that you could lose “infinite” money. When you buy a share and “go long,” the maximum you can lose is the amount you invested. When you “go short” instead, there are theoretically no limits to how much the stock price could go up, and thus to how much you could lose.
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 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.
Finally, don’t forget that short selling may not be free. Brokers may charge a fee for lending stocks, and there are fees for other short selling methods too. Be aware that these will partially lower your gains and increase your losses.
Protecting your portfolio
Say you hold a portfolio of stocks and you predict that a market crash is coming or a company’s stock is going to fall. To avoid losses to your portfolio, one option is to sell the stocks of the companies you hold before their prices drop – if you can get the timing right.
However, if you hold dividend stocks, you might prefer to keep them for the long run for the income. To avoid your portfolio falling in value without selling the shares, you could short the stocks by buying put options or selling call options, offsetting any losses.
Compare online trading platforms
The stock market moves in all directions, and short selling can help you take advantage of downtrends or bear markets. Depending on your investment goals and strategy, there are a number of ways to capture gains on falling prices. Evaluate which ones might be suitable for you and then compare online trading platforms that best fit the style of trading you want to do.
Frequently asked questions
The actual stocks that you can sell short 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.
"Kylie Purcell is the investments editor at Finder. She has a background in business and finance news with previous roles at SBS, Your Money, TVNZ, Switzer Group and The Adviser magazine. Kylie has a Master in International Journalism and a Graduate Diploma in Economics. When she's not writing about the markets you can find her bingeing on coffee.
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