A Beginner’s Guide to Short Selling

What is Short Selling? 

If you’ve spent any time reading about investing or watching CNBC you’ve probably heard the term short selling or shorting a stock.  But what does this really mean?  And more importantly-should you do it?  

How to Short a Stock 

To sell a stock short, you follow 5 basic steps:  

1. Borrow shares of stock from a stock broker
2. Sell the stock
3. Wait for the share price to (hopefully) drop
4. Buy back the shares at a lower price
5. Return the shares to the stock broker

Instead of hoping the price of a stock increases (as in traditional investing or going long), you are hoping the price drops so that you can sell high and buy low. Selling a stock short means you sell more shares than you own.   

At this point you’re probably asking, “Wait, how can I sell a stock I don’t own?”  That’s where your broker comes in.   

When you sell short, you technically are supposed to “borrow” the shares so that you have them to sell.  In reality, with the advent of online trading, all of this is done behind the scenes.  If you want to sell short, you simply enter the order to sell a stock in your account.  When the trade is processed, you will receive cash and see a negative number of shares (since you owe your broker.   

Even if you find a good candidate, short selling is extremely risky

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If Stocks Were Sculptures 

To try and better explain the abstract concept of shorting a stock, imagine stocks were sculptures.  Your friend has a sculpture (one of many identical ones) that the art market says is worth $1,000.  You think this is way overpriced, that the actual value is closer to $800 and pretty soon the art collectors will realize this too.   

So, what do you do? 

Being the opportunist you are, you ask to borrow the sculpture from your friend.  You then immediately sell it and make $1,000.  Now you wait a few weeks and just as you predicted the market value drops to $800.  So, you go out and buy the sculpture back and return it to your friend.  She has her sculpture back and you have an extra $200. 

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The Risk of Short Selling 

Short selling sounds pretty easy, but at this point, you may have realized that to succeed you have to root for the market to drop.  This goes against most people’s typical mindset.  Usually, we only see the market as going up.  This makes trying to find a stock we think will go down that much harder. 

Even if you find a good candidate, short selling is extremely risky. (tweet) It’s something I don’t recommend for new investors.

Since you don’t own the stock when you sell it, you need to have a margin account with your broker.  A margin account is where you borrow money from your broker to make trades.  Trading with borrowed money is a recipe for disaster, so if you really want to short a stock, make sure you have enough cash to cover the repurchase. 

The other risk is that your losses are essentially limitless. (gif of pulling up losses?)  When you buy a stock, you know its share price can’t go any lower than $0. But when you short a stock, you have no idea what how high the share price can go.  If you aren’t careful, you can lose a significant amount of money very quickly.  That’s why it’s important to set limits on your short sales.  Set an upper limit, so if the price increases by 5 or 10 percent (or whatever you are comfortable losing) the shares will automatically be purchased back.   

Related: The Best Investment for Time-Crunched Investors

How is Short Selling Legal? 

You may be wondering, how it’s legal for someone to sell something they don’t own and actively work against the market going higher? 

Short selling actually has a pretty long history.  The first short sale alleged occurred some 400 years ago in the Netherlands.  More recently, short selling became legal in the United States when the Securities and Exchange Commission (SEC) was created in the 1930s and adopted Rule 10a-1 in 1937. 

Rule 10a-1 became known as the uptick rule since it required a short sale to occur on a price one tick higher than the previous sale.  This helped ensure that short sellers couldn’t keep selling to drive a price down.   

The rule was removed by the SEC in 2007.  This has caused significant debate as to the role short selling played in the Great Recession and whether or not the uptick rule should be reinstated. 

Your Take 

Let me know what you think about short selling.  Is it a good idea or bad one for investors?  Should the uptick rule be reinstated? 

 

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