Short selling, also known as shorting or going short, is a way to make money by betting that a stock will drop in value. Short selling is used in both the stock and forex markets.

It is known as a trading strategy mostly used by experienced investors and hedge funds where they expect or speculate a decline in the value of a stock or security and generate profit from it. They do so by borrowing shares of a stock, from a broker or another investor, that they think will drop in price. When their prediction is correct, they buy back the shares at a lower price.

While shorting the stock goes against the traditional principle of trading, it is a valuable tool for traders, investors and portfolio managers to profit from falling stocks without having any inside information about the company’s business practices. However, it can be risky if the stock price suddenly increases instead of dropping.

It is not an easy feat, but it is possible and a great opportunity during a downtrend market, especially for investors who are willing to take the risk of capital loss. In this article, we discuss the various factors that will help you determine if this is the right investment strategy for you.

How to make money in short selling?

To better understand this investment technique, here’s a basic step-by-step guide on how to short a stock:

• First, identify which specific stock you want to sell short and that you have a margin account with a broker that allows you to open a short position.

• To get started, input the appropriate number of shares for a short order. Your broker will lend the shares and immediately sell them at the current market price, on your behalf.

• To close your short position, you buy back the shares at their new price. Since you technically don’t own it, you return the shares of stock to the broker and keep the difference as profit.

• If the stock price does fall, that’s when you gain profit. But if it rises, you buy back the stock at a higher price and accept losing money.

It sounds so simple, but it’s a totally different ball game when in practice.

Let’s say stock ABC is overvalued and is currently trading at $100. You believe that the stock price will fall in the next two weeks, but you don’t want to sell your ABC shares right now.

Instead of letting go of your own shares, you borrow from someone else (from a broker or another investor) and sell 100 shares at the current price.

You then receive $10,000 in cash proceeds, deducting all the fees charged by your broker, which is then credited to your margin account. Since you’re borrowing shares, you now have an obligation to repay them sometime in the future.

After two weeks, when the price of stock ABC falls to $60 per share, you can close your short position by buying back the same number of shares for $6,000.

At the start, you’ve collected $10,000, and now you are left with $4,000 which represents your profit. You are now able to return the borrowed shares and still keep the money from selling them in the first place (minus commission fees).

While short selling may seem complicated, it’s actually very straightforward once you understand how it works.

What are the advantage and disadvantages of short selling?

If you’ve heard of the GameStop fiasco in 2021, then you probably have an idea of how much of a risk it is to do short selling. But if you haven’t, here’s a quick rundown of what happened.

GameStop (GME) is an American gaming company whose stock price suddenly surged by 1,600 per cent in January 2021. It all started when individual investors and traders from WallStreetBets, a Reddit forum, collectively bought huge numbers of GameStop shares.

This drove up the stock price, causing a short squeeze and affecting hedge funds and short sellers that bet against GameStop.

Wall Street companies like Melvin Capital and Light Street Capital, both of which are managing hedge funds in the US, were known to have experienced the impact brought by the short squeeze that occurred with GameStop.

No amount of technical or fundamental analysis prepared them for what happened. There were investors that gained so much, while others suffered massive losses that eventually led to their bankruptcy.

A lot could go wrong in the stock market, so before you take on a short position, here are some pros and cons that you should consider.

Advantages:

Potential for high profits. If a trader correctly predicts the price movement of a stock, then they’ll receive a good return on investment. Short selling is a high-risk investment, but it yields high rewards.

Little initial capital is required. Borrowing shares help investors declare a short position in the stock market. Traders don’t need to put up much of their capital as an initial investment, and it allows them to leverage by using margin to initiate a trade.

Making money in a bear market. By initiating a short sale in a falling market, investors create a positive outcome despite the situation. Short sellers generate profit by speculating a decline in the price of a stock, which is an opportunity to make money in a bearish market.

Hedge against other holdings. Short selling provides an inexpensive way for investors to hedge an existing portfolio’s long-only exposure and reduces its overall market exposure and volatility.

Disadvantages:

Possibility for unlimited losses. Since they’re borrowing stocks to initiate a short sale, their debt obligation only grows as share prices rise. It can be quite expensive for traders and investors if they make wrong predictions about the stock price movement.

Margin requirement and interest incurred. It is required for short sellers to put up a margin, a percentage of which may vary depending on the eligibility of certain securities. A short position also incurs margin interest rates, which are charged by most brokers.

Trading restriction. There are limitations to the size, price and types of stocks that a trader can short sell. Not all stocks can be shorted, such as penny stocks.

Short squeeze. Traders can get caught in a short squeeze, which occurs when the price of a heavily shorted stock suddenly skyrockets, and short sellers try to hedge their position to cover their losses. When it happens, investors may be driven into severe losses or worse, bankruptcy.

The importance of short float in short selling

A float simply refers to the number or the percentage of shares that are available for trading in the public market.

A short float, also known as short interest, is the percentage of shares available to trade that are currently sold short. To calculate the short float, divide the number of shares sold short by the total outstanding shares for a stock or bond.

An important metric in short selling, short float determines an investor’s potential profit from trading a share for a particular stock and it somehow reflects the market sentiment about the underlying company.

An investor will use this figure to determine how much they need to worry about volatility caused by short selling. If a stock’s short float is high, it means that there are a lot of investors betting against that stock – which means that when they buy back their borrowed shares at lower prices (covering their positions), it drives down the price even further.

The fact that a stock has seen its short float increase over time doesn’t necessarily mean the stock is going to go down further. Other factors could be at play. There might be rumours of news that are about to come out, such as an earnings miss or some other negative development for the company.

Investors looking to make money off this information would want to set up for a short position before it becomes public knowledge because once it does become known, the price will drop in reaction, and it may not fall much more after that.

Investors who are thinking about investing in a company with high short interest should keep an eye on the stock’s daily trading volume – if it’s high compared with the average volume, there may be a significant near-term downside for this reason.

A short float is a great metric to consider when analysing a stock or the market before doing a short sale. If you are considering buying stock or bonds from a specific company and notice that many people have bet against its future growth, you might reconsider your position.

Short selling tips to remember before you get started

Short selling is one of the most misunderstood concepts in the trading world.

While investors and speculators often refer to it as a way to make a fast buck, many traders who frequently engage in short selling at times say that it’s actually a dangerous strategy. And while this isn’t always a bad thing, investors and speculators need to be mindful that there are risks involved with short selling.

Of course, you can’t really buy shares directly (because they’re not available), but you can borrow or sell some shares you own. This means that if things go right, you can profit by buying the stock back at an increased price later on, which is still cheaper than the IPO price. But if things don't work out – as they often do in markets like today’s – then you could lose everything.

Investors must learn that not all price movements are indicative of a stock’s performance, and they must watch out for the potential intent behind a price surge or decline before joining the bandwagon.

What happened with GameStop initially started for laughs and “memes”, but ended up as an act of revenge against Wall Street stockbrokers and hedge funds that bet against companies like GameStop, who at that time, weren’t doing well because of the pandemic. The aim was to make brokers and hedge funds lose money and these individual traders did it successfully.

Companies don’t really like it when they are being shorted. Short sellers see it as an essential part of markets. However, companies see it as investors profiting off the misery of others.

It is also important to know when to buy back the shares you’ve borrowed. When the stock price rises and starts to approach the price at which you shorted it, it’s time to cover your short and return the borrowed shares.

The extent of your profit or loss is determined in exactly the same way as a long position: If you covered or bought back the shares for less than you sold them for, you made money; if not, you lost money.

So, do you really gain profit from short selling?

Short selling is a riskier strategy than buying and holding long positions. Before making a short sale, you need to consider all the risks involved, especially if you have limited capital.

If you do have enough capital to invest in the stock market, then short selling stocks may be right for your portfolio. However, if you’re just starting out with investing or don’t have much money to spare, short selling may not be right for you.

As mentioned earlier, short selling should only be done by experienced investors who have advanced knowledge of the stock market and has the skills to anticipate and bounce back from unexpected losses.

Remember: Every investment has its own risks, and as an investor, one must do enough due diligence before taking on any trading strategy.