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You’re bearish on a company. It’s time to go short.

You have likely heard this before: Investors decide to “short” a stock in a company, for better or worse, but what does it mean and is there a time and a place every investor would need to make this move?

Shorting is a high-risk trading strategy for advanced investors. But with high risk could come … you guessed it, high reward.

The basics

Essentially, going short on a stock is when an investor sells something they don’t own.

You can sell 100 shares of stock in a company for $10 a share without even owning them yet. It takes a few days for transactions to clear, so those shares are borrowed.

The hope is that in the few days after the sale is made, the price of the company’s stock goes down (for example to $9 a share) in which case, they can be bought for $9 a share, and sold to a buyer for $10 a share. This gives that investor a $100 profit.

The strategy can obviously backfire. The stock could jump to $20 a share, then that investor would have to buy 100 shares at $20 a share and sell them for $10 a share. That’s a $1,000 loss.

Short selling requires due diligence but is still a gamble on if the stock will decline in price and is based purely on speculation. Investors or portfolio managers may use it as a hedge against the downside risk of a long position in that stock.

How to short sell stocks

These are the steps an investor can take to go short on a stock:

  • Identify the stock that you want to sell short
  • Ensure that you have a margin account with your broker and the necessary permissions to open a short position in a stock
  • Enter your short order for the number of shares (the broker will lend you the shares and sell them for you)
  • Wait for the stock to fall and then buy the shares back at the new, (hopefully lower) price
  • Return the shares to the brokerage you borrowed them from and pocket the difference

You don’t need to manually execute this process. There are many platforms available on your phone that can help your decisions.

  • Webull – A Simple platform for active investors looking to get started with short selling
  • TradeZero – For beginner to intermediate investors with engaged in short selling
  • TradeStation – Best suited to more advanced traders as it is very comprehensive, which can be overwhelming to novice investors
  • Interactive Brokers – For high volume traders looking for sophisticated tools

Hedging, put and call options

There are other ways to try to maximize returns on an investment.

A put option is a contract giving the buyer a right to sell (or sell short) a stock at a predetermined price, but not the obligation to do so. Along with stocks, put options can be traded on a number of other assets, such as currencies, bonds, commodities, futures and indexes.

On the other end is a call option, which gives the owner the right but not the obligation to buy the stock or asset.

Hedging is another common transaction involving placing an offsetting position to reduce risk exposure.

Short Squeeze

If a stock is shorted with a high short float (the number of tradable shares of a company’s stock) and days-to-cover ratio (the number of shorted shares divided by the company’s daily trading volume), it runs the risk of experiencing a short squeeze.

This happens when a stock rises and short sellers cover their trades by buying their short positions back.

Because everyone wants in on a good thing, this buying frenzy can turn into a loop. Demand for the shares attracts more buyers, which pushes the stock higher, causing even more short sellers to buy back or cover their positions.

A recent famous example is GameStop Corp. (NYSE:GME), whose short sellers have lost more than US$320 million in 2023.

Cons of short selling

An investor could stand to lose more than 100 per cent of his or her investment by playing a bad short. There is no price on value, and without a ceiling, a stock could rise well out of the realm of reason.

There is also a cost to doing this business. While the stocks were held on a losing effort, you must fund the margin account.

Pros of short selling

“No risk, no reward” applies to every facet of investing and short selling exemplifies that mantra all the way. If you can correctly predict the price moves in a stock or asset, you can net a decent return on your investment.

When done right, short selling can be a cheaper way to hedge, offering a counterbalance to other portfolio holdings.

Conclusion

Shorting a stock carries more risk than your casual investing experience, so be careful not to over-leverage your trading. While there is some potential for profit, it is limited while the downside risk is unlimited.

When you buy a stock, you either lose everything you put in, or you see massive returns (or something in between). But when you get in on a short sell, your losses could run far deeper than what you can manage.

It is a risky strategy, but if you follow the right advice, you could see better returns on an investment than someone whose experience was just owning stocks.

One of the best things an investor can do is stay informed on the companies and industries they are invested into. The best way to do that is to keep up with Stockhouse’s Trending News page here.

Join the discussion: Find out what everybody’s saying about public companies and hot topics about stocks at Stockhouse’s stock forums and message boards.

The material provided in this article is for information only and should not be treated as investment advice. For full disclaimer information, please click here.

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