What Is Shorting a Stock? How to Profit From Falling Stocks

When most people think about making money in the stock market, they think about buying stocks and then waiting for them to go up in value. This is known as “going long.”

However, there is another way to make money from stocks – by “shorting” them.

But what exactly is shorting a stock? How does that work?

Stay put as we go over the term with great detail!

The Basics of Short Stocks

Shorting a stock is the practice of borrowing shares of stock from somebody else and then selling the stock.

How does it work though?

For example, if you believe a firm’s stock will fall in value, you can borrow the shares and sell them on the open market.

You will then hope to buy the same number of shares back at a lower price so you can return them to the person you borrowed them from and pocket the difference.

This might sound a bit confusing, so let’s look at a short selling example.

Suppose Company XYZ is currently trading at $100 per share. You believe the stock is overvalued and that it will fall to $80 per share in the next few months. So, you borrow 100 shares of XYZ from your broker and sell them on the open market for $100 each.

A few months later, sure enough, the stock falls to $80 per share. You buy 100 shares back for $80 each and return them to your broker.

Your profit is the $20 difference between what you sold the shares for and what you bought them back for, minus any fees or commissions your broker charged you.

Important considerations:

How is this different from regular investing?

You’d think it’s pretty much the same, but let’s see why it’s not.

Borrowed Stocks

In regular investing, you don’t borrow stocks, you rather buy them with your own money. With shorting a stock, you’re borrowing someone else’s shares and then selling them, which makes the whole process significantly riskier.

Add this to the market volatility and the risk doubles. This is why shorting a stock is definitely not for the faint of heart.

Different Gameplay

Stock shorting imposes a different set of rules. For instance, it’s usually advised not to invest in a stock that has dropped more than 10% in one day compared to the previous day’s closing price.

The reason is that there might be a rebound, which would mean you’d have to buy the stock back at a higher price than what you sold it for, thus losing money.

Another rule of thumb is not to short stocks with a market capitalization below $500 million because they are more prone to manipulation.

Lastly, investors are also consulted not to short stocks that have already had a strong run-up in price. These are the most dangerous to short since they can continue to go up for some time, eating into your profits.

Why go for Short Selling Stocks?

Now, given the serious risk that is associated with this type of investing, it seems that you should probably steer away from it, right? Let’s talk about the benefits of shorting a stock.

The most obvious reason is, of course, to make money. If you are correct about a stock’s price going down and you short it, you can make a profit.

Another reason is that it allows investors to hedge their portfolios. A hedging strategy is one that seeks to offset potential losses by taking an opposite position in another security.

For example, let’s say you own 100 shares of Company XYZ and are worried about a potential decline in the stock price. To hedge your position, you could short 100 shares of Company XYZ.

If the stock price falls, the value of your long position will go down, but the value of your short position will go up, offsetting some of your losses.

Lastly, shorting a stock can also be a way to express a bearish opinion on the market or a particular sector.

Research is essential. Before you decide to enter such an investment, it is crucial that you understand the risks.

What are the Costs of Shorting a Stock?

Let’s say that luck is on your side, everything goes as planned and you manage to earn money. What would the costs for this procedure be?

Margin Interest

As we discussed earlier on, you need to have a margin account to be able to short a stock and that comes with certain fees.

You will be charged interest on the money you borrow from your broker to short the stock. The amount of interest you pay will depend on the amount of money you borrowed, the length of time you held the position and the prime rate.

Brokerage Commissions

Every time you buy or sell a stock, your broker charges you a commission. When you short a stock, you’re essentially selling it first and buying it back later, so you will be charged two commissions.

Capital Gains Taxes

If you make a profit on your short sale, that profit is considered a capital gain and is subject to capital gains tax.

The tax rate you’ll pay depends on how long you held the stock and what tax bracket you’re in.

Dividend Payments

When you short a stock, you may be responsible for paying the dividend to the person who lent you the shares.

For example, let’s say you short 100 shares of Company XYZ on Monday morning. The company pays a quarterly dividend of $0.50 per share on Wednesday afternoon.

This may be your responsibility, depending on your arrangement with the broker.

What are the Risks of Short Selling Stocks?

Worst-case scenarios time. What’s the worst thing that can happen?

Significant Financial Loss

The most obvious risk is that the stock price could increase instead of decrease.

Remember, the whole ordeal makes sense if the price of the stock further decreases. If by chance, the price goes up enough, you’ll be owing a lot of money.

Deficit of Stocks

There is a possibility that there might not be enough stocks to buy when the time comes.

This is what’s known as a “short squeeze.” A short squeeze happens when the price of a stock starts to rise and short-sellers are forced to buy the stock to cover their positions, driving the price up even more.

It can be difficult to predict when or if a short squeeze will happen, which is why it’s important to be aware of this risk before you enter a short position.

Timing

It’s possible that you waited too little or too long. Despite the company’s failure, it may take a long time for the stock to drop low enough for you to acquire again, and during that period, you are subject to interest rates and margin calls, which means you’re losing serious amounts of money.

When is the Ideal Time to Short a Stock?

Last but not least, let’s talk about the best time to short a stock.

During a Bear Market

The most ideal time for short sale stock is during what’s known as a bear market. A bear market is defined as a period of time when the stock market is experiencing a prolonged decline in prices.

Many investors choose short stocks during a bear market because they believe it’s an opportunity to make profits while the overall market is down.

When Stock or Market Fundamentals are Worsening

Another good time for short selling stocks is when the fundamentals of a particular stock or the overall market are deteriorating.

For example, if a company’s earnings are declining or it’s experiencing other financial difficulties, that may be a sign that its stock price will soon follow suit.

To be informed about these things, it’s important to pay attention to what’s happening in the overall market.

Summing It All Up

Shorting a stock can be a risky proposition, but if done correctly, it can also be profitable.

Before you enter a short position, make sure you’re aware of the risks and have a plan for what to do if things go wrong.

And finally, remember that timing is everything when it comes to shorting the market. Knowing when to enter and exit a position is crucial to your success.

Good luck!