Do you ever think that a company has seen better days and is on its last legs? Or maybe you believe that a pharmaceutical firm’s upcoming blockbuster drug will not be approved by regulators, making the company’s stock tank. Well, if you want to bet on a stock’s decline, you can do so by a procedure called short selling, or “shorting”.
While I don’t recommend it in general because it can be super-risky, it might make sense sometimes. So, today I’m going to show you how to short a stock.
How to Profit From a Price Drop by Shorting a Stock
How Short Selling Works
If you buy a stock, you’re obviously betting that it will go up in price – otherwise, you lose money when you eventually sell it, even if you may gain some dividends. But what if you want to make money when it goes down in price? To do so, you can short it. To see how to short a stock, let’s start by taking an example that illustrates how short selling works.
Step 1 – Borrow the Shares
So let’s say I believe that electric cars are the future, and I want to short an oil company like Exxon Mobil Corporation, whose stock trades on the New York Stock Exchange under ticker symbol XOM. My friend Jim doesn’t agree with me, and thinks XOM will go up because electric cars are too expensive for widespread adoption. So, Jim buys 100 shares of XOM as an investment. He’s a computer-hating Luddite, so he gets old-school paper stock certificates to represent his 100 shares.
To short XOM, I start by asking Jim to loan me his 100 shares. He comes up to my house and hands me the certificates, and I promise that, in the future, I’ll return 100 shares of XOM to him. He laughs at my foolishness, and drives off in his gas-powered car.
Step 2 – Sell the Shares “Short”
To take the next step in the shorting process, I have to find someone who wants to buy the 100 shares. So, I find Meghan and Harry, a young couple who want to invest in XOM. I sell them the shares (which go for around $78 each), and pocket $7,800.
Step 3 – Wait
I go back to my life, and let time pass. It turns out that I was right – Tesla takes over the world, and XOM drops to $10.
Step 4 – Buy to Cover
So to take my profit, I have to close out my short position. To do this, I first “buy to cover”, which just means that I buy 100 shares of XOM on the open market. I make sure to ask for paper stock certificates.
However, since the shares now cost only $10, 100 shares cost me just $1,000.
Step 5 – Close the Position
Finally, I take the certificates, and drive them back to Jim in my Tesla. I return the shares to him, and am done with it. Since I bought them for $1,000, I have a profit of $6,800 (the $7,800 I collected when I sold them “short”, minus the $1,000 it cost me to buy to cover).
And that’s how short selling works, in theory.
Here’s a good informational video that explains shorting:
Shorting A Stock with Your Brokerage Account
In practice, you don’t have to go through this mess. It’s all done automagically, through your broker. The first thing you have to do is open a margin account.
Basically, it’s a brokerage account that includes a line of credit. That means that your broker allows you to borrow money (from the broker) at your discretion, up to a margin limit. You have to apply for one, and your broker will probably check your credit, as if you were applying for a credit card. If approved, you can move to the next step.
Place A “Sell Short” Order
The actual trade mechanics might vary by broker, but the basic idea is to place an order to “sell short”, instead of buy. Once you try to place the order, your broker will tell you if the stock is available to borrow. If it is, you just place the order and wait for it to execute. Once it does, you’re officially shorting and have a short position open.
Your broker will take care of borrowing the shares for you. All you have to do is place the order, once you have a margin account. If it executes, the short position will be represented in your account.
Place a “Buy to Cover” Order
When you want to close the position, all you do is place a “buy to cover” order. Once it executes, your position is closed, and that’s it.
Here’s a man of the Internet showing how to short a stock on an online broker:
What if the Stock Goes Up in Price?
This is the huge risk of shorting, because your losses are theoretically unlimited. Let’s return to my XOM example (but say you sold XOM short through your broker). What happens if electric cars fizzle out, we enter a new age of oil, and XOM shares rocket up to $1,000 per share? You still have to close your short position at some point. So, yes, you might have to buy 100 shares for $100,000, because you’ve exhausted your margin limit and have to return the shares to whoever lent them to you!!!
Speaking about margin limits, if the shares you sold short go up too much in price, you’ll get a nasty margin call from your friendly broker.
What is a Margin Call?
It’s not just a movie. A margin call is when your broker tells you that you are at or beyond your margin limit. At that point, you’ll usually be asked to either expand that limit by depositing cash in your account, or to close your short position. If you don’t do it in a brief period of time (it could be hours), your broker will force-close the position for you, and you’ll have to take losses. As Charles Schwab says, “[j]ust as long positions in accounts with margin calls are subject to liquidation at the discretion of the Margin Department, a short position is also subject to possible closure when a margin call exists”.
Should You Be Shorting Stocks?
Now that you’ve seen how short selling works and how to short a stock, I’ll say that my personal opinion (not financial advice) is that most people should not be shorting stocks. It’s extremely risky, and you can have huge losses if you’re wrong. And even if you’re right in the long run, you may get a margin call if the stock appreciates in the short run, and be forced to take losses.
In my opinion, the overall best way to play the markets is to invest in broad index funds, and just buy and hold. I do think there’s a place for shorting, though, in circumstances like this:
- Using your “casino money” account (a small, non-retirement account where you experiment and have fun).
- Only taking small positions, where you can afford losses.
- Only with highly liquid, large-volume stocks where you can probably buy to cover quickly.
Also, beware of “gaps”, where the share has large price fluctuations between market close and the next day’s open. For example, say you short a small pharmaceutical company because you think their new wonder drug won’t be approved. The market closes, and news breaks that the drug is approved. The next day, the market opens with the shares 50% higher.
What a nightmare. Unless you’ve got lots of cash in your account, you’ll probably face a margin call, and large losses no matter what.
Summing It Up: Shorting A Stock
Well, now you know how short selling works and how to short a stock. In sum:
- Borrow a stock.
- Sell it on the open market.
- Wait for the price to go down.
- Buy to cover.
- Your profit is the difference between what you got when you initially sold it, and what you paid to buy to cover, minus costs.
If the circumstances are right (which would be very rarely for individual investors) you can use shorting to make money when a stock declines in price.
What do you think about shorting a stock and how short selling works?
Everything here is my personal opinion, and not financial advice. Also, it’s not a comprehensive, all-encompassing guide on how to short a stock or how to bet on the future price decline of securities. There are other ways to do that, including options and inverse ETFs.