Short Selling: 5 Steps for Shorting a Stock - NerdWallet (2024)

The commonly understood way investors make money off stocks is simple: Buy a stock with the anticipation that its price will rise over time, and if it does, sell it later for a profit. (Not sure how this works? Brush up on how to buy stocks.) This is considered “going long.”

But stocks don’t have to go up for investors to make money off them. Investors also can profit if the stock price falls — and this is the infamous short sell.

What is short selling?

Short selling a stock is when a trader borrows shares from a broker and immediately sells them with the expectation that the share price will fall shortly after. If it does, the trader can buy the shares back at the lower price, return them to the broker, and keep the difference, minus any loan interest, as profit.

Here’s an example: You borrow 10 shares of a company (or an ETF or REIT), then immediately sell them on the stock market for $10 each, generating $100. If the price drops to $5 per share, you could use your $100 to buy back all 10 shares for only $50, then return the shares to the broker. In the end, you netted $50 on the short (minus any commissions, fees and interest).

That sounds simple enough, but there’s a lot more to short selling stocks than just understanding the concept, and the strategy comes with the risk of serious losses.

How to short a stock in 5 steps

Why short a stock?

Investors may use a shorting strategy as a form of speculation. In other words, it’s a high-risk maneuver that could possibly yield high returns in exchange for taking on exceptional risk. Where a long-term investor may base their decision on thorough examination of the company’s financials, management and future potential, a speculator may base their decision on analysis of short-term price movements and market signals with the hope of quick profits.

One of those market signals is called short interest — the number of open short positions reported by brokerage firms on a given date. Short interest is often expressed as a percentage or ratio (the number of shares sold short divided by the total number of shares outstanding). High short interest indicates negative sentiment about a stock, which may attract more short sellers.

Shorting a stock also can be used as a hedge. Let’s say you own shares in a company and have doubts about its near-term performance, but don’t want to sell your shares. In this instance, you could continue holding your shares for the long-term while you short the stock, buying back in at a lower price if and when the stock’s value falls. The goal here is to offset the losses of your long position.

21 most-shorted stocks by short interest

Below is a table of the 21 highest-short-interest U.S. stocks on the New York Stock Exchange and the NASDAQ exchanges.

Source: Finviz. Stock data is current as of market close on May 31, 2024, and is intended for informational purposes only.

The risks of short selling

The biggest risk of short selling is the potential for unlimited losses.

In a traditional stock purchase, the most you can lose is the amount you paid for the shares, but the upside potential is theoretically limitless. When you short a stock, it’s the opposite — gains are maxed out at the total value of the shorted stock if the stock price falls to $0, but your losses are theoretically limitless, because the stock price can rise indefinitely.

Let’s look at the same example as above. You borrow 10 shares and immediately sell them for $10 each, generating $100. But then the shares rally to $50 each. Remember, you’re on the hook for returning the shares to the broker at some point, meaning you may have to buy them back for $500 — a loss of $400. If the shares rally to $100 each, you’d have to buy them back for $1,000 for a loss of $900. This, in theory, can go on indefinitely, and the longer you wait for the stock price to fall again, the longer you’re paying interest on those borrowed shares.

If this happens, a short seller might receive a “margin call” and have to put up more collateral in the account to maintain the position or be forced to close it by buying back the stock.

Given the market’s long-term upward bias, many investors find it hard to short stocks and achieve consistent, profitable results. What’s more, the risk — especially if you’re not sure what you’re doing — is much higher than a buy-and-hold strategy.

» Learn more about another option in a down market: inverse ETFs

What is a short squeeze?

One of the biggest risks of short selling is a short squeeze, in which a sudden rise in a stock's price scares away a lot of short sellers at once.

Closing a short position means buying the stock in question — so if a group of short sellers gets spooked into closing their positions by a price increase, they will all buy the stock around the same time, which could further increase the price of the stock (and thus any remaining short sellers' losses).

This can create a feedback loop in which short sellers' losses increase exponentially over time.

What is naked short selling, and why is it illegal?

Generally speaking, investors cannot short a stock unless they can borrow the necessary shares, or prove that they can obtain the shares within the clearing time of the short sale (the day of the trade plus two business days).

But there is also naked short selling — the illegal practice of short selling shares that the investor never actually obtained. Naked short sellers collect money by selling unavailable or nonexistent shares. They hope that shares will become available before the end of the clearing window so that they can actually purchase those shares and close out their short before the initial sale is even finalized.

Naked short selling can go very wrong in a number of ways and end up harming the unsuspecting person on the other side of the trade, which is why it’s banned in the U.S. The naked short seller may fail to purchase shares within the clearing window, or they may be forced to close their short trade by a margin call before they get ahold of the shares.

That can cause a failure-to-deliver, in which the person on the other side of the trade essentially gets swindled — they pay money for shares without either receiving those shares or getting their money back.

The bottom line on short selling

To summarize, short selling is the act of betting against a stock by selling borrowed shares and then repurchasing them at a lower cost and returning them later.

It’s a relatively sophisticated (and risky) trading maneuver that requires a margin account and a keen understanding of the stock market. It may not be appropriate for stock market beginners, and some short selling maneuvers, like naked short selling, are illegal because of the risks they pose to others.

Short sellers have been accused of hurting businesses, manipulating public opinion and spreading rumors about a company or stock. It's even been implied that short sellers are almost unpatriotic for not supporting publicly traded companies.

But short sellers often bring new information to light, leading the market to a more sober assessment of a company’s prospects. That can have the effect of keeping a stock at a lower price than it would have if only cheerleaders were on the sideline. The shorts help keep unbridled enthusiasm in check, and often they uncover fraud, aggressive accounting or just poorly run companies, information that may well be hiding in a company’s filings with the Securities and Exchange Commission. These are all valuable functions in the capital markets.

If you’re thinking about trying it, be careful. The SEC warns that most traders lose money in their first months of trading, and many never turn a profit.

It’s a good rule of thumb to only trade with money that you can afford to lose.

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