Short Selling

Short selling, or shorting, is a way to profit when a price falls. You borrow an asset you do not own, sell it at today's price and later buy it back, hopefully for less, to return it to the lender. The difference between the price you sold at and the price you bought back at is your profit or loss. It is the mirror image of a normal long trade, where you buy first and sell later.

How a short sale works#

Short P&L = (Entry price − Exit price) × Quantity − Borrow costs − Fees

Buying back to close a short is called covering.

The key risk: losses have no ceiling#

When you buy a stock, the worst case is that it goes to zero and you lose what you paid. When you short a stock, the price can keep rising, so the potential loss has no upper limit. A stock shorted at $80 can go to $160 or $400. This asymmetry is why short sellers must use stops, small position sizes and close attention to risk.

What shorting costs#

• Borrow fee: you pay the lender for the shares, as an annual rate charged daily. Most large stocks are cheap to borrow, but "hard to borrow" stocks can cost 20%, 50% or more a year. See Borrow Fees and Stock Loan Costs.
• Dividends: if the stock pays a dividend while you are short, you must pay that amount to the lender.
• Margin: shorting requires a margin account and collateral. If the price rises, you may get a margin call. See Margin.
• Recall risk: the lender can ask for the shares back, forcing you to cover at a bad time.

Short squeezes#

When a heavily shorted stock rises, short sellers start buying to cover their losses. Their buying pushes the price higher, forcing more shorts to cover, which pushes it higher still. This feedback loop is a short squeeze. In January 2021, shares of GameStop rose from under $20 to a brief intraday high above $480 in a matter of weeks, in part because of a squeeze on very large short positions. Traders watch short interest, the share of a company's tradable shares sold short, and days to cover to gauge squeeze risk.

Rules and restrictions#

In the United States, short sales must be backed by shares that can be located for borrowing; selling short without arranging a borrow, known as naked short selling, is generally prohibited. The SEC's Rule 201 also restricts short selling in a stock that has fallen 10% or more in a day, allowing shorts only at a price above the best bid for the rest of that day and the next. Other countries have their own rules and sometimes temporary bans during crises.

Other ways to profit from falling prices#

Borrowing shares is not the only way to go short:

Why short selling matters#

Short sellers are often unpopular, but they help markets work. They add liquidity, help prices adjust faster when companies are overvalued and have exposed accounting frauds by researching companies others were promoting. Many funds also short to hedge long positions, reducing overall market risk. See Hedging.

Frequently asked questions#

Is short selling legal?#

Yes, in most major markets, subject to rules on borrowing shares and occasional temporary restrictions.

Can you lose more than you invest when shorting?#

Yes. Because a price can rise without limit, losses on a short position can exceed the amount of money you put up.

What is a good stock to short?#

There is no safe short. Traders look for weakening trends and fundamentals, but must also check borrow cost, short interest and squeeze risk. Many prefer defined risk alternatives like put options.

Sources#

• U.S. Securities and Exchange Commission, Short sale
• Wikipedia, Short (finance)