You may have first heard of short selling when Reddit traders short squeezed GameStop, or maybe you heard about it in the movie “The Big Short.”
While many traders, think “buy low, sell high,” short selling is the opposite. Short selling is a trading strategy that bets that a stock will decline in price. Short sellers borrow stock at a higher price. The trader sells these shares, with the hope of buying them back at a lower price to return to the person borrowing the shares.
Short selling is risky because if a stock price increases instead of decreases, you can lose more than 100% of your investment.
What is Short Selling?
Short sellers believe a stock’s price will decline, so they borrow stock, sell it, and hope to buy it back at a lower price to return the borrowed shares.
Traders may use short selling purely for speculation, or to hedge a position. Short selling can bring large profits, but you can also quickly lose, theoretically, an unlimited amount of money. If you are a new investor, you may want to wait before you short sell stocks.
People like to short sell because it can help you make money when a stock, or the market, is on the decline.
What is a Short Squeeze?
A short squeeze is when a highly shorted stock dramatically increases in price, trapping short sellers. This causes many short sellers to close their position to prevent further losses, which can add to the increased price action since they need to buy stocks to close.
There’s have been several well-known short squeezes. One recent one gained widespread media attention with Reddit users in the “wallstreetbets” thread bought GameStop ($GME) stock, trapping the short sellers who bet on it declining.
Read More: What is a Short Squeeze?
What to Know When Short Selling
In order to short sell, you need to have a margin account. Note, the Financial Industry Regulatory Authority and the Federal Reserve have minimum requirements for the amount of money (maintenance margin) that must be kept in a margin account. If your account falls below that value, your broker may sell your position. Your broker may have additional requirements, too. You cannot short sell on a cash account. Learn more about cash vs. margin accounts here.
If you want to short sell a stock, you’ll also need to have the amount of money for the shares you’re buying, plus 50% of that value in your account.
Though many brokerages are now commission-free, many will charge interest on the shares you borrowed for short selling. And, some stocks considered “hard-to-borrow” may have an additional fee that can fluctuate.
If applicable, a short seller must make dividend payments to the person who is borrowing the stock to them.
If you’re looking to short sell, the best time to do so would be in a bear market, when a stock’s fundamentals decline and/or when technicals indicate a bearish trend.
Short Selling Data
There is data you can look at in regards to short selling. The first is short interest ratio (SIR). This is the ratio of currently shorted shares compared to the total number of available shares. This is also known as short float. If the SIR is high, it is associated with an overvaluation.
Another data point to look at is the days to cover ratio or short interest to volume ratio. This is the number of short shares divided by the average daily volume of the stock. The higher the value, the higher the indication of a potential bearish move.
Short Selling Examples
Say you think a certain stock is overvalued, so you borrow the stock for $100 per share. You then sell the shares. Later, you buy back the shares at $50 each. Since you sold the borrowed shares at $100, you’ve made a $50 profit per share.
However, an alternate scenario would be selling the shares at $100, but losing money. After you sell the shares, the company’s stock prices are on an upward trajectory. You need to return the shares you borrow, so you buy them at $150, with a loss of $50 per share. On top of that loss, you probably have to pay your broker margin or borrowing fees.
What’s the Risk?
When you are “buying low, selling high,” the maximum risk is your original investment price. If you invested $10,000 into Apple, the most you could lose is your $10,000. However, a stock can theoretically continually grow in price, which means if you are short selling the stock, the maximum loss you can get is really unlimited, though you’d likely buy shares to cover yourself before especially damaging losses. There are also deadlines to return borrowed shares, too.
While a company may be overvalued, it can take time for a stock to decline. It doesn’t just happen overnight—or even months. During that time, you’ll be racking up fees and face potential margin calls. You’ll also need to pay dividends if they are issued to the original holder.
Additionally, if a stock is a popular short position, you may have trouble finding shares to buyback.
Why Pay Attention to Short Sellers
One trading strategy could be seeking out popular stocks traders are shorting. If a short squeeze happens, that could cause gains in your trade. Be careful, though. Short sellers are betting against a stock for a reason—they think it will lower in price. While short sellers are not always right, it is something to think about in your strategy.
If you want to bet on a short squeeze, carefully analyze the stock to see if it is something you want to trade. People who trade short squeezes usually have another reason to enter the position, aside from high short interest.
A short squeeze can happen quickly, but then rapidly decline. As always with trading, make sure to do your proper research, keep your eyes on your position, and make trades at your own discretion.
Final Thoughts
Short selling is a method of trading that bets on the decline of a stock’s price. To do so, you borrow shares to sell and aim to buy them back at a lower price to return them. This strategy is risky, and it is not recommended for beginner traders. If you’re not interested in short selling, paying attention to short interest can inform your day-to-day trades.
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