Investors wanting to short stocks need to do so through a margin account and need to be aware of the risks of betting against securities. Short selling can be a risky practice, but it’s now an activity that is relatively easy for retail investors to get involved with.
But how can retail investors short stocks and what risks or advantages might they have to take in their stride?
What is Shorting?
Shorting a stock is effectively betting against it. Normally, while trading equities you’re looking for the companies with a share price that is going to climb upwards and result in your investment growing in value.
With short selling, you’re basically looking for the opposite. Short sellers try to work out which stocks are going to decline in value and use shorting to benefit financially from any decline in value.
It's not just stocks either. A wide range of securities can be shorted.
It’s a risky way of operating, but the rewards can be outstanding, and it appeals to traders who like to make bold plays.
Just think of the likes of Dr Michael Burry, Steve Eisman and Gregg Lippmann, who shorted collateralized debt obligations (CDOs) before the US housing market crashed in 2008. Their moves were seen as crazy at the time, but they secured massive returns and saw their stories immortalized in the Hollywood movie The Big Short.
How Does Shorting Stock Work - Example
In practice, shorting stock goes a little like this. An Investor A might decide that Company A’s stock is a good option to short, having determined that the share price is likely to fall in the future.
The investor will seek to borrow shares from somebody invested in the company, let’s call them Investor B and let’s say they lend 10 shares of Company A to Investor A. Investor A will probably have agreed to pay some sort of fee to Investor B as part of the borrowing agreement.
Investor A will then sell the 10 borrowed shares to someone else.
Then, it’s a matter of Investor A waiting to close out their position. This is done by purchasing 10 shares in Company A to replace the borrowed shares which they sold. These 10 shares can then be returned to Investor B.
If the share price dropped by 10% between the sale of the borrowed shares and Investor A closing out their position, they have made a profit (minus any fees or interest they agreed to pay to their broker and Investor B).
But if the share price has climbed, Investor A has made a loss and may have closed their position as an act of damage control – cutting their losses before they spiral out of hand.
Want to find out the benefits of shorting? Read about the positive influence of short sellers!
How to Short Stocks
So, now we understand the principle behind shorting stocks and we’ve seen how it works. But how can you actually go about shorting stocks.
For starters, you will need access to a margin account. This is a kind of brokerage account where your broker or dealer will lend you money to purchase securities. These accounts allow investors extra purchasing power and give them access to riskier securities.
However, there are big drawbacks. For one thing, as you are borrowing and pay interest fees, your losses can be more severe. Additionally, you might have to pump more money and assets into your account to cover losses and the brokerage firm may even sell some of your holdings without warning in order to pay off debts.
When you use your account to short a stock, a certain amount of the funds in your account will likely be set aside. This is the margin requirement and is effectively held as collateral in case your position incurs significant losses.
Different brokerage platforms have different inbuilt processes for shorting stock. Broker platforms that allow shorting include:
Types of Shorting
Though this article mainly refers to shorting equities, investors are able to short a variety of securities. This means exchange traded funds (ETFs), index funds, commodities and bonds can all be bet against by investors who think they have determined a price drop in the near future.
Advantages of Shorting Stock
One way in which shorting is particularly appealing is that it carries the possibility of enormous returns for a relatively small initial cost. Since you are only borrowing the stock that you are shorting, you only have to pay that fee to your broker or the party you have borrowed from.
Shorting can also be an effective way of hedging your portfolio against Bear markets, as at least one of your investments is likely to benefit from a downturn in the stock market.
Disadvantages of Shorting Stock
The primary disadvantage of shorting stock is that your losses can be enormous. When you simply buy a stock and it turns out to be a poor decision, the worst that can happen is you lose your original investment.
With short selling, the stock price can rocket to huge levels that an investor might not have expected and they will be forced to purchase the stock when they seek to close out their position. Bear in mind that there is theoretically no upper limit to how much a stock’s price can increase by.