What Is Short Selling and How Does It Work?

Most investors make money when a stock rises. Short sellers aim to profit when a stock falls. It's a legitimate strategy used by professional investors, but it carries risks that make it unsuitable for most beginners.

How shorting works

1. You borrow shares of a stock from your broker.
2. You sell the borrowed shares at today's price.
3. Later, you buy the same number of shares back, hopefully at a lower price.
4. You return the shares to the lender and keep the difference, minus costs.

Example: you short 100 shares at $50, receiving $5,000. If the price falls to $35, you buy them back for $3,500 and make $1,500 before costs. If the price rises to $70 instead, buying back costs $7,000 and you lose $2,000.

Requirements and costs

• A margin account is required, with collateral held against the position.
• Borrow fees: you pay interest to borrow the shares. For heavily shorted stocks this can be very expensive.
• Dividends: if the stock pays a dividend while you're short, you owe that amount to the lender.
• Margin calls: if the price rises, your broker can demand more collateral or close your position at a loss.

Why the risk is different

When you buy a stock, the most you can lose is what you paid. When you short, there's no ceiling on how high the price can go, so losses are theoretically unlimited. Meanwhile the most you can make is 100%, if the stock goes to zero. Over the long run the stock market has tended to rise, which works against short sellers.

Short squeezes

When many investors are short and the price starts rising, short sellers rush to buy shares back to limit their losses. That buying pushes the price even higher, forcing more short sellers to buy. The result, a short squeeze, can send a stock up dramatically in days, regardless of the company's fundamentals.

Reading short interest

Short interest is the number of shares currently sold short, often shown as a percentage of the shares available to trade. High short interest means many investors expect the stock to fall, which is worth investigating, but it also raises the risk of a squeeze. "Days to cover" divides short interest by average daily volume to show how long it would take short sellers to buy back.

Alternatives for cautious investors

If you're worried about a stock, simply not owning it, or trimming your position, is the low-risk choice. Some investors use stop-loss orders (see order types) or put options instead. For most long-term investors, a diversified portfolio is the best protection against any single stock falling.

This article is educational and not investment advice.