How an Investor Can Make Money Short Selling Stocks

Suppose you think that Company X is overvalued at $200 per share and that its price is due to go down. In his book The Big Short, author Michael Lewis portrayed a cast of characters who warned of the impending housing crash. Below is a table of the 21 highest-short-interest U.S. stocks on the New York Stock Exchange and the NASDAQ exchanges. We believe everyone should be able to make financial decisions with confidence.

Short selling limits maximum gains while potentially exposing the investor to unlimited losses. A stock can only fall to zero, resulting in a 100% loss for a long investor, but there is no limit to how high a stock can theoretically go. A short seller who has not covered their position with a stop-loss buyback order can suffer tremendous losses if the stock price rises instead of falls. To short a stock, the trader borrows shares from a broker-dealer and sells them in the open market. If the stock’s price declines in the future, then the trader buys the stock back at the lowered price and returns the borrowed number of shares back to the broker-dealer, keeping the profit for himself.

The bottom line on short selling

Let’s say you own shares in a company and have doubts about its near-term performance, but don’t want to sell your shares. In this instance, you could continue holding your shares for the long-term while you short the stock, buying back in at a lower price if and when the stock’s value falls. To maintain the short position, the investor must keep enough equity in the account to serve as collateral for the margin loan — at least 25% per exchange rules. However, brokerages may have a higher minimum, depending on the riskiness of the stocks as well as the total value of the investor’s positions.

A Short-Selling Alternative With Less Risk

Whereas most investing involves buying an asset and selling it later at a higher price, short sellers start by selling an asset and then buy it back later, hopefully at a lower price. Since a company has a limited number of outstanding shares, a short seller must first locate shares. The short seller borrows those shares from an existing long and pays interest to the lender. If a small amount of shares are available for shorting, then the interest costs to sell short will be higher. If the seller predicts the price moves correctly, they can make a positive return on investment, primarily if they use margin to initiate the trade.

Short-term speculation is risky in general, but if you’re set on betting against a stock, perhaps consider other ways of doing so, such as buying put options on it. As you can see above, the short squeeze then began in earnest in January 2021. As the share price rose, those with short positions had to buy shares to close the position and prevent additional losses. That increased demand for GameStop shares, driving the price even higher.

Criticism of Short Sales

• A smart trader could have seen this rapid price increase and realized that it was probably unsustainable.
• Short selling was also blamed for the 1929 and 1987 stock market crashes.
• Traders use short selling as speculation, and investors or portfolio managers may use it as a hedge against the downside risk of a long position.
• This is a publicly available list of securities with FTDs for five or more consecutive trading days and is used by regulators to identify potential cases of market manipulation.

For long positions, they favour good management teams, an historically high return on invested capital, good free cash flow, and an ability to preserve capital through difficult cycles. The Big Short highlights the sub-prime mortgage meltdown which ultimately led to the global financial crisis. It also highlights the complex financial terminology in the industry, using vivid and humorous ways to highlight complex tools (such as Collateralized Debt Obligations (CDOs) and mortgage-backed securities). When the value drops below that threshold, your brokerage will require you to replenish the account. Your brokerage also may ask you to cover your short position when the price has gone up.

Strategies and techniques in short selling

Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology rfp software development and the social studies of finance at the Hebrew University in Jerusalem.

Short selling is a strategy for making money on stocks falling in price, also called “going short” or “shorting.” This is an advanced strategy only experienced investors and traders should try. An investor borrows a stock, sells it, and then buys the stock back to return it to the lender. Now you can close the short position by buying 100 shares at $70 each, which will cost you $7,000. You collected $10,000 when you initiated the position, so you’re left with $3,000. That represents your profit — again, minus any transaction costs that your broker charged you in conjunction with the sale and purchase of the shares.

Depending on the scale and nature of the short, it has the potential to magnify losses, playing havoc with natural price discovery occurring in the markets. However, Joe’s losses would have multiplied if ABC’s share price had increased. Suppose ABC’s share price skyrocketed to $200 in the next two years and his dealer wants the shares back.

When it all goes according to plan, short-selling can yield impressive returns. However, it can also lead to substantial losses, especially if a short squeeze occurs, such as the one that took place during the Gamestop trading frenzy. Vehicles for passive investing, such as exchange-traded funds, guarantee safer bets through fixed returns and fewer losses. By contrast, if the stock soars, there’s no limit to the profits you can enjoy. It’s quite common for long-term stock investors to earn profits that are several times the size of their initial investment. Specifically, when you short a stock, you have unlimited downside risk but limited profit potential.

This “bait-and-switch” tactic allegedly netted Left and his firm $20 million. Hindenburg Research became even more well-known for its investigation into the Adani Group, a prominent Indian conglomerate owned by Gautam Adani, rsi day trading who was then the world’s third richest man. Almost immediately, about $100 billion in the stock value of the Adani Group was gone. You decide that ShortMe Co. (a fictional company) is poised for a steep decline and decide to short 200 shares at $50 per share.

You may also need to add more money into your margin account to avoid what’s known as a margin call—when the value of the securities in your account fall below a certain level. Essentially, both the short interest and days-to-cover ratio exploded overnight, which caused the stock price to jump from the low €200s to more than €1,000. Timing really is everything in short selling, which is why a fund manager should be your first port of call with this type of strategy. Stocks typically fall in value much the wisdom of finance: discovering humanity in the world of risk and return: a review faster than they grow – remember, shorting too early can be extremely painful. One month later, the share price has now dropped to 70p – meaning they can benefit from the lower share price. A manager can then buy the share back for 70p, return the share to the broker and make money on the difference (30p minus trading costs).

How does short selling work?

But there are plenty of dangers; your upside is really capped at two times your investment, but the downside loss is unlimited from a mathematical perspective. You also lack control and are dependent on the market, as short positions can be squeezed. A good example of this was when the share price of the American chain of bricks-and-mortar video game stores GameStop rose dramatically in 2021. Naked short selling can go very wrong in a number of ways and end up harming the unsuspecting person on the other side of the trade, which is why it’s banned in the U.S. The naked short seller may fail to purchase shares within the clearing window, or they may be forced to close their short trade by a margin call before they get ahold of the shares.