Short Selling: The Risks and Rewards

Many traders try to profit from stocks that rise in value. But some do the opposite—their idea is profiting from stocks that decline in value—through a strategy known as short selling.

Short selling involves borrowing a security whose price you think is going to fall and then selling it on the open market. You then buy the same stock back later, hopefully for a lower price than you initially sold it for, return the borrowed stock to your broker, and pocket the difference. 

For example, let's say a stock is trading at $50 a share. You borrow 100 shares and sell them for $5,000. The price subsequently declines to $25 a share, at which point you purchase 100 shares to replace those you borrowed, netting $2,500.

Short selling may sound straightforward, but this kind of speculative trading involves considerable risk. Here's a closer look at how it works—and what to consider before taking the plunge.

Because you're borrowing shares from a brokerage firm, you must first establish a margin account to hold eligible assets like bonds, cash, mutual funds, or stocks as collateral. As with other forms of borrowing, you'll be charged interest on the value of the outstanding shares until they're returned (though the interest may be tax-deductible). Interest rates can vary significantly. You may be able to short the most liquid shares for nothing, while the least liquid shares could come with an annualized interest rate of more than 100% of the value of your position. —They can also change suddenly if the shares become more or less liquid. Interest accrues daily at the prevailing rate and is deducted from your account on a monthly basis.

Also worth noting: Your broker will have to "locate" the security you're targeting before you can do a short sale. This is a regulatory requirement aimed at preventing "naked shorting," which is when a trader attempts a short sale without actually taking delivery of the borrowed shares. The rule says your broker must have a reasonable belief the security can be borrowed and delivered on a specific date before you can short it. Attempting a naked short could lead to your position being closed by your broker, potentially resulting in significant losses or costs.

Once you've opened and funded your margin account, you can start to research possible short-sale candidates. Traders typically use one or more of the following approaches to identify short-sale targets:

• Fundamental analysis: Analyzing a company's financials can help you decide if its stock may be a candidate for a decline in price. For example, when looking for short-sale candidates, some traders look for companies whose earnings per share (EPS) and sales growth have been slowing, in the expectation that the company's share price will follow suit.
• Technical analysis: Patterns in a stock's price movement can also help you decide if it could be on the cusp of a downtrend. One potential signal could be when a stock has fallen through a series of lower lows while trading at higher volumes. Another could be when a stock has rebounded to the upper range of its trading pattern but appears to be losing steam.
• Thematic: This approach involves betting against companies whose business models or technologies are deemed outdated (think Blockbuster Video), which can be more of a long game but can pay off should your prediction prove correct.

As for which might be best: That's generally in the eye of the beholder. Each approach—or even combination of approaches—involves a certain amount of analysis and interpretation.

As with any trade, you should identify your entry and exit points before you begin. You may also want to consider entering a stop order to help limit your losses in the event the trade moves against you. 

In general, two kinds of stop orders may prove useful:

• Buy-stop orders trigger a market order to buy back the shares at the next available price if the stock price rises to or above the stop price. Remember, the goal is buy back stocks at a lower price than you sold them for, so a bounce higher could hurt. 
• Trailing buy-stops specify a stop price that follows, or "trails," the lowest price of a stock by a percentage or dollar amount that you set. If the stock rises above its lowest price by the trail or more, it triggers a buy market order. If the price drops, the stop resets at a lower price.

However, neither method guarantees that the order will execute at or near the "stop" price you designate, and in fact, the stop order could lock in significant losses if the price gaps up.

Now for an example. Let's say stock XYZ recently dropped from $90 per share to $66 before rebounding to $84, and you think it's poised for another decline. After researching company fundamentals and analyzing recent price movements, you might decide on the following trade plan:

• Enter a short position only if the stock falls below $80 per share.
• Set a buy-stop order at $84 in the hope of limiting a potential loss to $4 per share.
• Close out the position at or below $74 per share.

Short selling comes with numerous risks:

1. Potentially limitless losses: When you buy shares of stock (take a long position), your downside is limited to 100% of the money you invested. But when you short a stock, its price can keep rising. In theory, that means there's no upper limit to the amount you'd have to pay to replace the borrowed shares.

For example, you enter a short position on 100 shares of stock XYZ at $80, but instead of falling, the stock rises to $100. You'll have to spend $10,000 to pay back your borrowed shares—at a loss of $2,000. Stop orders can help mitigate this risk, but they're by no means bulletproof.

Losses for short-sellers can be particularly heavy during a short-squeeze, which is when a heavily shorted stock unexpectedly rises in value, triggering a cascade of further price increases as more and more short-sellers are forced to buy the stock to close out their positions. Each wave of purchases causes the stock's price to surge higher, hurting anyone holding onto a short position.  

2. A sudden change in fees. As noted above, the cost to borrow a stock changes frequently in response to supply and demand conditions. For example, you could log off one night with a short position carrying a 20% interest rate, only to log in the next day to find it has surged to 85%. As a result, you may find it no longer makes sense to keep your position open. Even worse would be a case where both the value of the stock you've shorted and the accompanying interest rate are rising at the same time, sending your cost to carry skyward.

3. Dividend Payments. Short sellers aren't entitled to dividend payments from the shares they've borrowed. In fact, the value of any dividends paid will be deducted from short-seller's account on the pay date and delivered to the stock's owner. Some short sellers choose to close their short positions before the stock's ex-dividend date to avoid having to pay. (As a reminder, the ex-dividend date is the first day a stock's price no longer includes the value of a declared dividend. That's because the value of the next dividend payment is owed to the stock's owner.)

4. Margin calls: If the value of the collateral in your margin account drops below the minimum equity requirement—usually 30% to 35% of the value of the borrowed shares, depending on the firm and the particular securities you own—your broker may require you to deposit more cash or securities to cover the shortfall immediately.

For example, as long as your 100 shares of stock XYZ remain at $80 per share, you'll need $2,400 in your margin account—assuming a 30% equity requirement ($8,000 x 0.30). However, if the stock suddenly rises to $100 per share, you'll need $3,000 ($10,000 x 0.30)—requiring an immediate infusion of $600 to your account, which you may or may not have.

If you fail to meet the margin call, your brokerage firm may close out open positions to bring your account back to the minimum requirement.
 

At its most basic, short selling involves rooting against individual companies or the market, and some investors may be opposed to that on principle.

However, if you have a firm conviction that a stock price is heading lower, then shorting can be a way to act on that instinct—so long as you're aware of the risks.