Shorting a stock explained

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It’s possible to make money in the market no matter which way it moves — up, down or sideways (which are the only three ways markets can move).

For new investors, this often seems like a strange concept. It might seem as though the only way to profit in the markets is to buy a security at one price and sell it later at a higher price.

Of course, not all assets move upward in price all of the time. So what do investors do when they’re reasonably certain that a particular stock or market industry will be trending lower soon?

Shorting a stock, also known as short selling, “being short” or simply “shorting,” is one way to potentially profit during a downtrend. This strategy is popular among savvy, risk-tolerant investors who have a knack for market research and predicting trends.

Related: Importance of time horizons for investing

What Is Shorting a Stock?

Shorting a stock is a way for investors to make a bet that the future share price of a particular stock will be lower than its current price. There are multiple ways this can be accomplished, which we’ll get to later. For now, we’ll focus on the standard definition, which implies the use of a margin account.

To short a stock, an individual first borrows shares from a brokerage firm that currently holds a position in the stock, which that person is interested in shorting. This transaction will happen through a margin account, which is required by the federal government to regulate broker lending to investors.

Then, the borrower sells the borrowed shares on the open market to another investor, with the plan that when the stock price drops even further, the borrower will buy back the same number of shares they borrowed (or more, if they choose), in order to return them to the brokerage firm.

If the share price of the stock the borrower shorted has declined, they can buy the same shares for less money and pocket the difference.

But that outcome is not a guarantee. If the share price has increased, they will lose money because they now have to buy the same shares for a higher price.

Here’s a quick hypothetical example.

Let’s say an investor found a company that they think is overvalued and might see its share price fall very soon.

They borrow 100 shares of stock in company A at a price of $10 per share for a total of $1,000 (plus any applicable brokerage fees). Three things can happen at this point: The stock can rise, fall or trade sideways. If the stock trades sideways, the investor will only lose whatever they had to pay in fees and commissions. Let’s look at two other, more likely possible scenarios.

In Scenario A, the investor made a prediction that was spot-on and the price falls to $9 per share. Great! That’s what investors want. Now they can buy back 100 shares at a price of $9 for only $900, and the leftover $100 is the profit.

In Scenario B, the investor made a call that missed the mark, and the price rises to $11 per share. Now they have to buy back 100 shares at a price of $11 for a total of $1,100, for a loss of $100.

Selling a stock short involves significant risk — far surpassing the risk of buying and holding (also called “going long” an investment). When holding a stock, investors can only lose as much as their initial investment. If someone were to buy 10 shares of XYZ company at $10 per share, for example, and the share price goes to zero, they will lose $100. The price can’t go lower than zero, so someone can never lose more than what they had first invested.

However, when someone shorts a stock, they risk infinite losses due to the fact that there is no upward limit on a stock’s share price. As long as the price keeps going up, they will keep losing money.

By now, the answer to the question “what does shorting a stock mean?” should be more clear.

Why Is Anyone Interested in Shorting a Stock?

There are three main reasons people might choose to short a stock:

  • The hope of making fast profits
  • Seeking potential returns during market downturns
  • As a hedge against long positions

While risky, shorting a stock could be profitable. It’s possible to make a lot of money in a short period of time by using various short strategies. Sometimes stocks see rapid, steep declines. This can occur as a result of circumstances unique to a specific stock or because of broader market conditions.

During recessions, for example, rapid drops in the share prices of many stocks across many different industries can occur. While this might cause the portfolios of many investors to decline, others are able to profit by shorting.

One reason investors might choose to short a stock is to hedge against their long positions. The term “hedge” is used to refer to an investment that protects against losses in another asset. In this case, we’re talking about short positions being used as hedges against long positions.

For example, say someone has 100 shares of stock in a company that deals in real estate and is classified as a real estate investment trust (REIT). The investor has researched the company and believes it has sound fundamentals, high-quality management, and will continue to grow into the future.

But, in this hypothetical scenario, there could be cause for concern. An investor won’t know how the real estate market will react to current events over the course of the coming months and years.

Maybe they figure there’s a chance that real estate prices could be heading lower in the near term, even though they’re still a believer in the stock they purchased and the industry as a whole.

In this case, investors might consider shorting a stock in the same industry or a related one.

To hedge an imaginary long position in this specific REIT of non-real real estate, an investor might decide to take a short position in either a different REIT or perhaps an inverse exchange-traded fund (ETF) that provides short exposure to real estate (such as the UltraShort Real Estate SRS ETF, which tracks the Dow Jones U.S. Real Estate Index). This way, if the hypothetical REIT loses value, their short position will increase in value, offsetting their losses.

In this way, shorting can be used as a method of managing risk, aka hedging.

There’s nothing wrong with investing this way. In fact, managing risk could allow investors to minimize their losses, although doing so will also cap their gains.

Is Shorting a Stock Wrong?

There are some negative connotations surrounding the concept of short selling. These conceptual associations are mostly meritless. So, why do they exist?

It’s difficult to say for sure, but shorting may have received a bad rap by being associated with shady investors who have, at times, spread malicious rumors about a company in the hopes of influencing its share price.

They may have secretly opened short positions in the stock and were trying to use false information to convince other investors to sell, leading to profits for anyone who was short.

But this kind of trickery goes both ways. There have also been investors who sought to manipulate the price of a stock upward by spreading bullish rumors that turned out to be false.

This practice is known as market manipulation and it is illegal. Anyone who gets caught attempting to manipulate markets might be subject to legal punishment by regulatory agencies like the Securities and Exchange Commission (SEC)  or the Financial Industry Regulatory Authority (FINRA).

How Does Shorting a Stock Work?

We’ve covered some ground in terms of answering the question, “What does shorting a stock mean?” By now, readers might be wondering how it works in practice.

Three main ways investors might establish short positions include:

  • Margin accounts
  • Put options
  • Inverse ETFs

Margin Accounts

As mentioned, shorting a stock in the traditional sense most often requires trading on margin because a margin account offers leverage beyond the existing cash balance of an investor’s brokerage account. Investors might need this credit extension because when shorting a stock, they may lose more money than they invest, possibly even more than the balance of their entire account.

With a simple cash account, investors can only invest or lose what they have right now. But trading on margin might give someone, say, two-times, or 2x, leverage.

Say an investor has $1,000. With a cash account, they can only work with investments that cost $1,000 or less. But with a margin account that offers 2x leverage, they can trade with up to $2,000.

Trading on margin is considered to be very high-risk because it can amplify rewards or losses significantly.

Put Options

If a brokerage account allows investors to trade options, placing put options on a stock allows them to profit when it declines in price.

A put option is an options contract with two key parameters: an expiry date and a strike price. The expiry date is when the contract will be exercised and the strike price is the price at which the contract will be “in the money,” meaning it will net an investor a profit once it passes that price to the downside (or, in the case of call options, the contract would be in the money once the underlying security passes the strike price to the upside).

For example, imagine that an investor wants to short an imaginary stock that we’ll call ABC company. Shares of ABC are currently selling for $10. The investor believes the company is overvalued and the stock will soon head to $8 or lower.

So, he or she buys a put option for ABC with a strike price of $8 and an expiry date three months in the future. If ABC stock falls under $8 to $6 during that time, hypothetically, this investor would make money on her put option. That’s because by exercising the put option, an investor can sell shares at a price higher than the current market value. In the hypothetical example, the investor could sell ABC shares for $8 per share when the market value is $6 per share, a difference of $2 per share.

Options contracts could be profitable (and risky), but trading them requires more knowledge than trading something like an inverse ETF. With options, investors have to decide to buy a call option, put option or a combination of several options at once. Then they have to pick from a wide range of potential strike prices and expiry dates.
Trading inverse ETFs, on the other hand, is as simple as buying a stock.

Inverse ETFs

Inverse ETFs can be easier to trade than put options. Investors can buy shares of an inverse ETF just like they would buy an ordinary stock.

These investment vehicles aim to provide returns in opposition to the performance of a particular index.

They perform in the opposite (inverse) direction of the thing they track. In other words, when the asset or index that an inverse ETF follows goes down, shares of the inverse ETF should go up. On the other hand, if the asset or index goes up, the inverse ETF should go down.

Note: Put options and inverse ETFs suffer from something called time decay. Underlying the concept is the fact that as time passes, and, say, a put’s expiry date approaches, there is less time for the stock price to go in the direction you expected.

As a result, the value of options contracts declines over time (an investor is willing to pay less for a week’s chance of a stock price moving than for a month’s chance of a stock price moving). Inverse ETFs, in particular, involve rapid time decay. This is because time decay accelerates the closer you are to the expiry, and inverse ETFs rebalance their investment strategies each day.

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This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.

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