Short selling is a bet that a stock's going to slump in price. It can mean big profits if the drop does happen. But it can also lead to large losses, if the shares' price rises.
  • Short selling means selling stocks you've borrowed, aiming to buy them back later for less money.
  • Traders often look to short-selling as a means of profiting on short-term declines in shares.
  • The big risk of short selling is that you guess wrong and the stock rises, causing infinite losses.
  • Visit Business Insider for more stories.

In traditional, buy-and-hold investing, the interests of investors are aligned with the securities they own. When the stocks or other assets do well, the investor earns a profit. And when the investments depreciate in value, the investor takes a loss.

But this isn't the only way to make (or lose) money in the stock market. Some traders actually look to earn profits by betting against stocks. The strategy is called short selling. It involves selling borrowed stocks in anticipation of a decline in price.

Short-selling is a high-risk, high-reward trading strategy. When things go according to plan, going short can yield impressive returns. But it can also lead to big losses, especially if a short squeeze occurs as infamously took place during the recent Gamestop trading frenzy

While hedge fund managers and professional traders are the most prominent players in the short-selling arena, any investor with a margin account can go short on a stock. But are the potential benefits of short selling worth the risks? Here's what you need to know.

What is short selling?

Short selling, aka shorting or taking a short position, is when traders or investors sell stocks they've borrowed in hopes of buying them back later for less money. Generally, short-sellers borrow the shares from their broker. The broker may lend from their own inventory, another broker's inventory, or from clients who have margin accounts and are willing to lend their shares.

Margin interest must be paid on the shorted shares until they're returned to the lender. And if any dividends are paid out while the shares are on loan, the short-seller must pay for them as well. These costs will decrease the short-seller's overall profit or exacerbate their losses.

Regardless of how a shorted position performs, the borrowed shares must eventually be returned to the lender. If the share price goes down, the short-seller can buy them back at the lower price, return them to the lender, and pocket the difference for a nice profit. But if the price goes up, the trader may be forced to close the position at a loss.

To participate in short selling, you must have a margin account with your broker - a special brokerage account that allows you to borrow. You'll also need to meet your broker's initial and maintenance margin requirements. Suppose that your broker has a 50% initial margin requirement on shorted stocks. In this case, you'd need to have at least $10,000 in your account to open a $20,000 short position.

How does short selling work?

Let's look at how a short sale of XYZ stock might work. Currently, the stock is being sold for $100 per share. You believe that the stock's price is primed to fall and short 100 shares for a total sale price of $10,000.

Now let's assume that your hunch was correct and the share price for XYZ drops to $80. You buy 100 shares to replace the ones you borrowed for a total price of $8,000. Excluding interest (and dividends if they apply), you profit would be $2,000 ($10,000 - $8,000 = $2,000).

But suppose you guessed wrong on XYZ and the price actually spikes to $120 per share before you finally decide to close your position (by your replacement shares) and cut your losses. At $120 per share, you'd have to pay $12,000 to replace the 100 borrowed shares, resulting in a $2,000 loss ($10,000 - $12,000 = -$2,000).

What's the advantage of short selling stock?

Traders primarily participate in short selling - or going short, in traders' lingo - as a means of profiting on short-term declines in a stock's value. The use of margin in short selling is also attractive to many traders, as it means lower capital requirements and the potential for high profit margins.

For example, a trader with $25,000 in a margin account may be able to take a short position of up to $50,000. Now suppose the underlying stock depreciates by 10% to $45,000 before the position is closed for a $5,000 profit. In this case, the trader's profit is actually 20% since only $25,000 of capital was put at risk ($25,000 x .20 = $5,000).

A trader may also decide to go short on a stock in order to hedge against a long position (that is, shares they already own outright). For example, let's say you're an investor in ABC stock: You own 200 shares at an average price of $40 per share. You don't want to sell, but you're also worried about the company's short-term prospects due to a negative news event, a disappointing earnings report, or some other reason.

In this case, you may decide to short 200 shares of ABC at $40. Once the stock's value drops below $40, your long position begins to lose money. However, the profits from your short sale are able to negate those losses.

We'll assume that ABC drops all the way to $35 per share before beginning to rebound. At $37 per share, you decide that ABC is on the comeback trail and exit your short position to lock in profits and avoid eating into the eventual profits of your long position (in which you benefit from ABC's appreciation).

What are the risks of short selling?

The big risk of short selling is that you could guess wrong and stock may go up. And the risk of guessing wrong is higher with short selling than with traditional investing. Here's why.

When you buy a stock, your upside is unlimited, while the maximum you can lose is all of your investment or 100% (in the event that stock price falls to $0). But, with short selling, the exact opposite is true. Your maximum profit is 100% (again if the stock drops to $0) while your loss potential is technically infinite.

Suppose you short a stock at $25 per share. If the stock were to drop all the way to $0, your profit would be maximized at $25 of profit per share. But if the trade goes against, the stock could rise to $50 (100% loss), $75 (200% loss), $100 (300% loss), or even higher.

Other notable risks of short selling include:

  • Appreciation trend: The stock market tends to rise over the long-term. So the overall trend is against you as a short-seller. 
  • A short squeeze, which happens when a stock rises sharply and suddenly and short-sellers scramble en masse to buy shares to cover their position. Each of these buy transactions drives the stock even higher, forcing more short-sellers to exit their positions...and the vicious cycle continues. Short squeezes typically happen when a high percentage of all the stock's outstanding shares are being sold short. 
  • Margin dangers: Using margin, which short selling does, comes with a few risks of its own. First, you have to pay interest on the borrowed stocks until they're returned. Second, if the shorted stock rises significantly in value, the broker could issue a margin call, requiring you to add cash or securities to your account to cover the amount you borrowed. If the margin call isn't met (typically within two to five days) the broker has the right to sell the stock itself, locking in your losses.

The financial takeaway

Short selling is essentially a bearish or pessimistic move, requiring a stock to decline for the investor to make money. It's a high-risk, short-term trading strategy that requires close monitoring of your shares and of the market. For these reasons, it may not be a suitable strategy for individual investors who prefer taking a passive, long-term approach with their portfolios.

For active traders or investors into market-timing, though, short selling is a strategy that can produce positive returns even in a period of negative returns for a stock or the market as a whole. But if you do decide to short stocks, make sure you fully understand the risks and have a clear exit plan for getting out of the short, if the stock price starts to rise against you.

Related Coverage in Investing:

'Buy the dip' means purchasing a promising stock when its price drops, assuming a fast rebound and future profits

Trading and investing are two approaches to playing the stock market that bring their own benefits and risks

How to diversify your portfolio to limit losses and guard against risk

Volatility measures how dramatically stock prices change, and it can influence when, where, and how you invest

Options let you lock in a good price on a stock without actually buying it - here's how option trading works

Read the original article on Business Insider

Receive a daily news update on your cellphone. Or get the best of our site emailed to you

Go to the Business Insider front page for more stories.