What Is Shorting a Stock?

You might have heard traders refer to "shorting" or "short selling" a stock. But what is shorting a stock? And is it a strategy you should consider?

Let's start with the basics. When you buy a stock – or "go long," in trader-speak – you're betting that the share price will rise.

Shorting a stock is the exact opposite. When you short a stock, you're betting that the share price will decline.

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So shorting a stock means you're betting against it.

The mechanics of going long are simple. You pay cash to buy shares from an existing shareholder looking to sell, and your broker handles the details behind the scenes.

Shorting a stock is more complicated because you are selling something that you don't own.

What is shorting a stock using an example? 

Shorting a stock is best explained by an example.

Let's assume you believe shares of Microsoft (MSFT) are overpriced and you expect the price to decline in value.

You decide to sell short 100 shares of Microsoft and place the trade with your broker.

Here's what happens next.

Your broker will borrow 100 shares from another investor to lend to you, which then immediately gets sold. Assuming Microsoft's shares are trading at $350 per share, you receive $35,000 in cash.

But that's just the beginning.

Once you sell shares short, you are obligated to buy the shares back at some point in the future, and during the period that the shares are sold short, you have to pay interest. (Remember, you borrowed them).

The interest rate will vary based on the availability of shares to short. If it is a heavily-shorted stock with limited inventory available to sell, it's going to cost you more in interest.

Let's say Microsoft's shares drop to $340. Great! You can close out the trade by buying 100 shares. You sold at $350 and bought back at $340, netting a $10 per share profit, or $1,000.

Of course, it could also go the other way.

If the Microsoft shares had climbed to $360, you would have spent $36,000 buying them back, meaning you would have lost $1,000.

What are the risks of shorting a stock?

When you buy a stock – assuming you didn't go wild and buy it on margin – your loss is limited.

You can potentially lose your entire investment, but you can't lose more. And your upside potential is unlimited.

A stock can't fall more than 100%, but it can theoretically keep rising until the end of time.

With a short sale, the math gets turned upside down.

Your profit is capped at 100%, and that is if the stock literally falls all the way to zero. But your downside is theoretically unlimited.

Now, generally, "unlimited risk" is manageable if you are careful. If you see the trade getting away from you, you can buy to cover before the losses get out of control.

And your broker may force you to close the position if the value of your account gets close to falling below zero.

But all of this assumes a normal, orderly market.

Things can get nasty fast in the event of a short squeeze. In a short squeeze, a heavily shorted stock starts to rise, which forces the short sellers to buy back the shares they sold short to stop their losses.

This forced buying by the short sellers causes the stock price rise to accelerate, forcing other short sellers to join in the panic buying. This is part of what sparked the GameStop (GME)/meme stock craze in early 2021.

If you're not careful, a short squeeze can wipe you out.

Is it a good idea to short a stock?

If you are an experienced investor comfortable with taking and controlling risk, there is absolutely nothing wrong with shorting a stock.

Why not make money on the downside, particularly during bear markets when prices in general are falling?

Just be smart about it. Understand that the mechanics of short selling are very different than for buying stocks, as are the risk profiles.

You should also avoid heavily shorted stocks that would put you at risk of getting short squeezed.

And, as is the case with any trade or investment, you should keep your position sizes manageable.

If done carefully, shorting a stock is a useful skill that can allow you turn a profit at precisely the time most investors are suffering.

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