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Trading on the stock market can be a risky endeavor, but investors are always finding ways to profit off it, even if a stock they’re interested in falls in value. Stock market declines of 5% to 10% generally require a month’s recovery time, but these declines aren’t bad news for all traders.

A lot of investors make money from stocks that go down during declines by implementing a strategy known as short selling, also referred to as shorting a stock. However, this is a risky strategy, and you need to know everything about it before you get into short selling.

What exactly is short selling?

Short selling is a strategy where a trader borrows shares and sells them immediately while also expecting that the price for those stocks will soon fall. When that happens, the trader can buy the shares back at a lower price than the one they were originally valued for.

The next step is to return the shares to the broker from which they originally borrowed the stocks and profit off the difference.

For example, if you borrow 10 shares of a company and sell them for $10 apiece, you will generate $100. And if the price suddenly drops to $5 per share, you can use that same money to buy the shares back, ending up with a profit of $50.

This may sound simple, but there is a lot more to this investment strategy. If you want to learn how to short a stock, you need a lot more than the knowledge of how it works.

This trading strategy requires a lot of speculation as you can never be sure if or when the prices of stocks will fall. Speculation carries the possibility of considerable risk, which is why only experienced traders are usually brave enough to take on short selling.

How short selling works

As we already mentioned, short selling typically requires borrowing stock, which means you will be trading shares that are owned by somebody else.

When the trader wants to close a short position, they wait until the price of the borrowed stock they sold declines. Then, they simply buy them back for a considerably smaller price. And once they make a profit, they return the borrowed stock and repeat the process again and again.

But before you can close a short position, you need to open one first. To do that, you need to have a margin account and pay interest on the shares you borrowed for as long as the position is open. You wouldn’t be able to get into short selling without a margin account.

However, you should realize that as a broker, you need to have a certain amount of money in this account which is known as the maintenance margin. The minimum value is set by the New York Stock Exchange (NYSE), and the Federal Reserve.

Short selling can be a great way to earn a profit on the stock market in a very short time, but it’s never guaranteed as there are a lot of risks.

Take the example we gave above into consideration. If you believe the price of a certain stock is overrated, you purchase 10 shares, and if everything goes according to plan, you would walk away with a profit of $50.

However, if the stock doesn’t decrease in value as you expected, you would still have to buy it back as it’s borrowed stock, and you would be looking at a loss.

Pros and cons of short selling

As you have probably figured out by now, short selling has a few upsides and downsides to it. Since it’s a high-risk strategy, it can cause you to lose your money, but it can also lead to incredible profit – both very possible options.

Let’s look at short selling pros and cons a bit more closely.

The pros of short selling

If you’re able to correctly predict the movement of the price of a certain stock, you will have a great return on your investment, especially if you initiate the trade with margin. When you use margin, the initial investment doesn’t require too much of your capital.

The pros of short selling include:

1. Potentially very high profits with little initial capital required.
2. Leveraging possible investments.
3. Hedging out your portfolio’s long-only exposure while also reducing its overall market exposure.
4. Using the capital proceeds you earn from short selling to overweight the long-only components of your portfolio.
5. Reducing the overall volatility of your portfolio due to the exposure to both short and long positions.

The cons of short selling

The high risk of short selling we mentioned before includes the following disadvantages you might experience with this type of trading:

1. There is no limit to how much stocks could rise, so you might end up with a huge loss.
2. It’s almost impossible to predict if the value of a stock will fall or rise.
3. Running the risk of the stock you borrowed being recalled by the broker.
4. The risk of short squeezes (significant and rapid price moves) will bring out a lot of short sellers, in turn pushing the prices of the stock.
5. Trying to borrow less-liquid stocks is usually expensive.
6. Volatile market conditions may cause a ban of short selling altogether.

When and why should you sell short?

A big part of learning how to short a stock is learning why you should sell short and when would be the perfect opportunity.

You should sell short if you believe the price of a stock is going to drop soon. Some traders use speculation when selling short, while others do a thorough examination of the financials, management, and future potential of the company whose stocks they’re planning to sell short.

The more important question we need to answer is when to sell short. There are certain situations when short selling makes perfect sense, or in other words, when the conditions are ideal. Going in too early or too late will cause you to make a lot of mistakes and lose out on some great opportunities.

But if you wait for the perfect moment, you can almost guarantee success. Here are a few examples of good conditions for short selling:

1. During a bear market. A bear market occurs when securities prices fall 20% or more so people who want to profit off short selling have the best chances of doing so during this time. One of the most famous bear market ever was the US bear market of 2007–2009, which lasted for 17 months.
2. When fundamentals are deteriorating. There are a lot of reasons why a stock’s fundamentals might deteriorate, but the reason isn’t important for selling short. Bad fundamentals might lead to weaker data that usually indicates an economic slowdown and leads to a bearish trend.
3. When there are elevated levels for valuations. Sometimes, rampant optimism might lead to elevated levels for valuations of certain sectors or the market. A lot of investors will be disappointed when their expectations aren’t met, but short sellers wait for the market sector to roll over and earn a profit.

What else do you need to know before selling short?

Besides the cons of short selling we already mentioned, you need to be aware of the following things related to short selling and all the risks that we still haven’t explored:

1. Margin accounts. When you open a margin account, you use your investments as collateral when you borrow money from the brokerage. You’re required to meet the minimum maintenance of 30% on your account; otherwise, you will have to either put in more cash or liquidate your position.
2. Timing. You can never be sure how long it will take for stock prices to decline, even if a company is overvalued. And while you wait for the prices to drop, you will be vulnerable to margin calls, interest, and even being called away.
3. Regulatory risks. In some cases, regulators can ban short selling in certain sectors or even in the broad market. This is done to avoid causing panic or selling pressures which can lead to a sudden spike in stock prices, which leads short sellers to cover their positions and take huge losses
4. Not going with the trends. If we look at the history of the stock market, stocks usually have an upward drift, and most stocks accelerate in price in the long run. That means that short selling goes against the trends and when you trade like this, you’re ignoring the overall direction of the market.
5. The short squeeze. When stocks begin to rise and short sellers start to buy their short positions back to cover their trades, it might cause a feedback loop known as the short squeeze. The demand for shares will attract even more buyers, which will, in turn, increase the price of stocks and the cycle will continue.

How to short a stock

Now, let’s go into detail on how to short a stock.

1. As we already mentioned, you will need a margin account. The process for obtaining one varies from one brokerage to another, but you will probably need approval before you can open the account.


2. You will have to have either stock equity or cash in your margin account that will serve as collateral to make any trade. It needs to be equivalent to at least 150% of the value of the short position as stated by the requirements made by the Federal Reserve.


3. If you fulfill these requirements, you can enter a short-sell order in your brokerage account and acquire a short position, meaning you can borrow shares.


4. To maintain your short position, the equity in your margin account needs to be at least 30% per exchange rules. It’s also important to note that you will pay interest for the shares for as long as you have them.


5. And finally, when the stock price falls, you can close your short position, buy out the borrowed shares, and return them to the broker. Just don’t forget to take the interest, commission, and fees into account when calculating your profits.

The controversy around short selling

Finally, you need to be aware that there is a lot of criticism surrounding short selling. Short sellers have been accused of a lot of negative things, including manipulating public opinion, hurting businesses, and even spreading rumors about the stocks of a certain company or even the company itself.

Short sellers are often viewed as ruthless operators who are out to destroy companies and their profitability. Unfortunately, the controversy around short selling occurs due to the unethical speculators and all the practices they employ such as market manipulation. This is illegal, but still happens.

However, if you understand short selling, you realize that it actually provides liquidity to markets as it fills them up with enough sellers and buyers. They can even stop bad stocks from rising due to over-optimism and unnecessary hype.

They keep this unbridled enthusiasm in check and in some cases even uncover fraud, poorly run companies, and aggressive accounting. Short sellers can bring a lot of new information to light and cause a more sober assessment of some companies’ prospects.

Final thoughts

Learning how to short a stock can be a very profitable venture and the process itself is very simple once you learn the ropes. However, this is in no way a good strategy for traders who don’t have enough experience because it takes a lot of knowledge and practice to come out on top while short selling.

Before you get into this form of trading, you need to weigh the risks and rewards very carefully and be sure that short selling is the right choice for you. So, tread lightly and happy trading!