If you’ve been following the stock market at all this year, you’ve almost certainly heard of the term short selling. But have you wondered what short selling stocks actually means?
When an investor takes a short position in a particular stock, they’re speculating that over time, the price of the stock will decline. It’s a calculated guess that a stock’s price will drop, and really should only be utilised by experienced investors.
How do I short a stock?
Shorting a stock requires access to a margin account from which the investor can borrow leverage to carry out the trade. When short selling, the investor borrows shares of the stock at the current market price, and then sells them to buyers. Since they are expecting the price of the stock to drop, the short seller is calculating that they will be able to repurchase those shares at a lower price. Therefore the difference in the amount made from initially selling to buyers and then re-purchasing those shares at a lower price, nets the short seller a tidy profit.
Short Selling Example
Let’s take everyone’s favorite stock Tesla (NASDAQ:TSLA). It’s perhaps the most polarising company on the stock market and has plenty of bulls and bears. For example, let’s say the short seller wanted to short the stock when it was priced at $500.00 per share. The short seller borrows 1,000 shares of Tesla at $500.00, so they’re borrowing $500,000 worth of Tesla stock.
The short seller immediately sells these shares to buyers at the current market price of $500.00. Now, the short seller plays the waiting game, and if their speculation on Tesla’s stock declining is correct, they should be able to make a nice profit.
Several weeks later, the stock price of Tesla fell to $400.00 per share. The short seller will then close their short position and purchase 1,000 shares of Tesla stock at $400.00. These shares will be ‘returned’ to the broker, and the profit left in the short seller’s account is: $500,000 – $400,000, which equals to $100,000.
The Risks of Short Selling
Like with any form of investing, there is inherent risk in short selling stocks. Short selling can be devastating to an investor if they speculate incorrectly on a stock price declining. If the stock price rises, there are near unlimited losses that can be incurred by the short seller. Going back to our Tesla example, if the stock price rose to $600.00 instead of falling to $400.00, the short seller would incur a loss since they would have to ‘cover’ their short position by repurchasing those shares at a higher price.
In a real world example, this is exactly what happened to hedge funds in the meme stock short squeeze event in early 2021. Institutions like Melvin Capital held significant short positions in both GameStop (NYSE:GME) and AMC (NYSE:AMC), so when retail investors artificially boosted the prices of the stocks, hedge funds had to cover their short positions by buying back shares at a higher price. This led to the stock price skyrocketing in what is known as a short squeeze.
Another risk with short selling is that a brokerage can request a margin call to the short seller. A margin call is when the brokerage requests that the amount borrowed is paid back immediately or financial penalties can be incurred. A badly timed margin call can be detrimental to a short seller if the stock price has not declined.
Benefits of Short Selling
As with non-short selling, the ultimate goal of being a short seller is of course to make a profit. There are other reasons to short a stock though, including one which does not necessarily indicate a bearish outlook. Hedging is a term often used in investing. After all, hedge funds are named so because investment managers take both a short and long position in each stock. Shorting a stock can be used as a hedge to protect a long position in a stock. This means that the short seller is actually bullish over the long-term, but is using a short position to capture any volatility or downside during that time.
When executed correctly, short selling can provide investors with a large potential profit with minimum initial investment. Since most short selling is used through margin, much of the actual investment is borrowed money.
Costs of Short Selling
There are some additional costs to shorting stocks. First, operating in a margin account always comes with margin interest on the borrowed amount, as well as the potential for a margin call. You will also incur any brokerage fees for executing trades, so keep these things in mind before looking at starting a short position in a stock!
Disclaimer
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