Shorting a stock can be a risk-laden prospect, and is certainly not recommended for newer, not-ready-for-prime-time investors.
That's right - it's easy to lose money when you short a stock, and investors should know that. You're essentially betting that a stock will drop in value, and you're borrowing shares of a specific stock, then selling the stock with the hope that the stock declines enough to repay the "short" loan, and still earn a profit.
Worse, the clock is always ticking on a short sale. After all, the more a stock climbs after you bet on it to fall, the longer it takes to fall to a suitable figure for a short seller to make a profit (if it ever does at all.) Consequently, a short seller always wants the stock price to decline as soon as possible, to maximize any profit earned on the transaction.
With that warning out of the way, let's take a look at shorting a stock, examine just how risky it is, and walk through the process of actually shorting a stock.
What Is Shorting a Stock?
Short selling amounts to betting that a given stock will decline in value - in Wall Street lingo, that's called having a "short" possession. Having a "long" possession means you actually own the stock, and are betting that it will rise in value.
Short sellers don't actually own a stock. They have to borrow shares from someone else (usually a stock brokerage firm that owns the security, or who has a customer who owns the stock and is willing to loan it out) in order to sell it at the price it's selling at the time of the transaction (that's known as the current market price.)
The idea is to repurchase the stock after it declines in price, and then kick back the borrowed stock shares to the original lender, with interest payments on the loan. The profit comes in the difference in the money earned from the short sale and the cost of repurchasing the shares (known as "covering" a short stock position.)
An Example of a Shorted Stock
Here's an example of shorting a stock.
Let's say an investor short-sells 500 shares of XYZ stock, which trades at $10 per share, and collects $5,000 from the transaction. And let's say XYZ stock falls to $5 per share. In that scenario, the investor could repurchase 500 shares of the stock for $2,500. Once that transaction is complete, and the XYZ stock loan is repaid, the investor has pocketed a profit of $2,500 from the short sale.
For a "real world" short sale example, consider Tesla, (TSLA - Get Report) the controversial auto manufacturer. The stock has been heavily shorted in 2018 after rumors new vehicle deliveries are stuck in "delay" mode and after repeated instances of company founder Elon Musk making wild statements about the company.
In August, the short scenario on Tesla wasn't looking good. The company's stock rallied 16% after a good earnings report, and total Tesla stock shorts amounted to $2 billion in losses - at that time.
But fast forward to September, when the U.S. Department of Justice announced Tesla was the subject of a criminal investigation. The stock fell by almost 30% and Tesla short sellers were finally rewarded for betting on the company's stock to fall.
Why Would You Short a Stock?
The fact is, the investors most likely to short a stock are deep-pocketed ones - think pension funds, stock brokerage firms, hedge funds, and other institutional investors. They may be speculating about a stock, but it's just as likely they'll short a stock for other, more defensive-minded reasons from a portfolio management point of view.
Primarily, you would short a stock for several reasons:
- You believe a stock's price is set to decline.
- You want to hedge a long position you've already taken in a stock (maybe even the same stock.)
- To gain a tax advantage.
- To capitalize on a potentially negative event at a publicly-traded company, like a corporate takeover, lousy corporate earnings, a change in management, a failed product or service, or some form of a business scandal.
Although the myriad moving parts involved in a short sale make the process risky, the actual steps needed to execute a complete short sale are fairly direct. Here's how to get the job done:
1. Open a Margin Account With Your Brokerage Firm
A margin account allows you to borrow stock (or cash) to expand your investment options - including a short sale. Be prepared to answer some candid - even tough - questions from your brokerage firm about your suitability to handle more investment risk that comes up with a short sale.
2. Identify the Type of Account You Want to Open
You can usually open an individual, joint, corporate or trust account to follow through on a short sale.
3. Direct Your Broker to Execute a Short Sale on a Specific Stock
Stock brokerage order tickets are fairly uniform. You can check a box to "buy," "sell," or "short" a stock. If you don't see the box for a short sale, contact your broker and ask him or her to follow through for you.
4. Make Sure You Know the Rules Before You Sign Off on the Short Sale Order
Brokerage firms have different rules on short sales and you'll need to know what your firm requires. For example, some brokers place limits on the number of shares you can borrow. Others may not have the shares you need. Again, a talk with your broker should clear the matter up in no time.
5. Buy the Stock Back and Pay Off the Loan
Hopefully, your short-sales stock has declined and you'll earn a profit. Even if not, and you lose money on the short sale position, you'll still have to buy the stock back eventually and repay the loan. In this instance, write up a "buy" order (usually referred to as "buy to cover") on a stock brokerage order ticket. That will indicate to the broker you want to cover your short sales by buying shares of the stock back, repay the loan with interest, and formally complete the short sales process. If there is money left over in your account from the short sale order that's your profit on the deal. Note also that if there are any dividends earned on a short sale deal, they'll need to be returned to the broker, who is the original owner of the stock.
The Aftermath of a Short Stock Deal
The good news, in theory, is that it doesn't take too long to figure out if you're going to make a profit on a short sale.
The process usually takes months rather than years. If it does take longer, it usually means a short seller is waiting for the stock to decline. In that time frame, though, stock losses can stack up, and you could wind up losing a significant amount of cash on a short sale deal.
Your largest risk in the short-sale process is of the shorted stock actually going up in value. That's a problem and here's why.
Every dollar gained by the stock is a dollar that's working against your short position, as each dollar gained is a dollar lost by the same amount in a short sale deal. The real trouble begins if the stock rises high enough to double in value - a nightmare scenario for a short seller as that means the short position has collapsed to zero value. At that point, your lender (likely your broker), can demand you pay back the loan against the stock shares borrowed in a short sale transaction.
A "margin call" can also come into play in a short sale process and, once again, that's not good news for a short seller.
A margin call is when a broker orders you to steer more cash into your brokerage account to cover a loan taken out for a stock position that is losing value. If you can't cover a margin call, the broker can close the account, and charge you for any investment losses incurred.
In a unique way, a short sale amounts to the old retail warning about "buyer beware."
It can be a risky proposition, but if you do your due diligence, scour research reports and read up on a company's financial health, and conclude there are ample reasons for the stock to decline, a short sale is a good tool to take full advantage of a struggling company. (Tesla is a textbook example of that scenario.)
These days, with the stock market generally on an upward trend, it's not easy to zero in on a stock about to go into decline. But flawed stocks do exist, and for a smart short seller, they could be ripe for picking.
If not, it's the short seller who winds up being the one who's "picked" - and the one whose stock brokerage account may be emptied out.