What Is Short Selling?

Written by True Tamplin, BSc, CEPF®

Reviewed by Subject Matter Experts

Updated on August 10, 2023

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Short selling is a way to profit by borrowing an asset, such as stocks or bonds, and selling it with the intention of purchasing it at a later date for a lower price.

If successful, that strategy profits you the difference between the two prices minus interest on the amount borrowed and commission fees.

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When Should You Consider Short Selling Stock?

When to short a stock can vary depending on your market analysis.

However, there are several situations you might consider:

  • When the company is in financial trouble and appears like it could go bankrupt
  • If its forecasts or expectations aren't met
  • During earnings season (the time of the quarter where companies report their quarterly profits)
  • If you see a lot of pessimism in the market

To make a profit, the share price must decrease or "fall" at a rate greater than your interest on the loan and commission fees.

Shorting a stock is riskier than buying because you sustain a loss if the price increases instead of decreases.

How To Execute a Short Selling?

Executing a short-selling strategy can be most difficult, but there are several steps that will maximize your chances of success.

  1. You need to borrow the stock from your broker using either his margin account or own cash as collateral.
  2. After borrowing it, place a "short" order to sell the shares at a higher price than you expect they will be in the future.
  3. You must buy back those shares later and return them to your broker.

Benefits of Short Selling Stock

Short selling offers several benefits:

  • It can be profitable in any market and doesn't require high-risk tolerance.
  • It provides an opportunity to make money when an investment thesis has failed.
  • If done correctly, it can allow you to profit from market pessimism.

Short selling can be very profitable if an investment loses value.

There is a limited loss for shorting stock because the only money spent is the commission on repurchasing it unless the stock takes off and goes up.

Then commission fees will add to your losses.

Drawbacks of Short Selling Stock

The drawbacks includes:

  • You can be subject to a "short squeeze," where a few investors buy all the available stock to force its price higher, forcing you to close your position by repurchasing it at a higher price.
  • It can also be challenging to find shares available for borrowing, and the lender may demand that you put up collateral.
  • Your borrowing costs can be high (though it's worth noting this is usually offset by the fact that you make money when the price goes down)
  • There is always a risk of infinite losses if the company goes bankrupt or has positive news that turns the market in its favor

Tips in Short Selling Stocks

Short selling is a risky business. If the stock price does not go down, you have to repurchase it at a higher price just so that you can give back what you borrowed.

With all these factors being considered, it might seem complicated to know when to short sell a stock, but there are some tips that will help you get started.

  • Buy Low and Sell High

This might sound like a plan from the past, but it's still valid in today's world, where everything seems to be going digital. In short selling, this is even more important.

If you think a company is doing good and its stock price will go up, it's better to wait and then buy. If you don't have that much time or patience to sell at a higher price, consider other options.

To maximize your profit from a stock you have borrowed, you have to sell it at the right time. The more volatile a particular market is, the tougher it is to get good returns on your investment.

Often, people make money in a stock, but they don't turn around and sell it at its peak value. For this reason, it's essential to be able to make smart trading decisions when you are given a chance to short-sell stocks.

  • Compare the Price to Earnings Ratio of Other Comparable Stocks

You might think that the current stock price is too high, but if it's still below the price-to-earnings ratio (P/E) of similar companies, then you might as well go for it.

Short selling stocks isn't something that everyone can do. Even if you know what you're doing, there are still some risks involved, so practice caution when trading this way.

For example, the stock price might go down instead of up for several reasons, and it might be hard to get out at just the right time. This is why you need to always stay on top of the market and know how your stock performs.

Several websites will let you compare the price to earnings ratio for other stocks to find out whether it's better to sell now or wait a bit longer.

  • Avoid High Fluctuating Stocks

If a company's stock price is known to fluctuate a lot, it might be hard for you to enter and exit the position in time before you make a loss.

This type of risk can't be calculated in detail, but some tools will help you determine the volatility of a specific stock to determine how risky it is.
Short selling isn't for everyone.

It's a risky business, but some people are already familiar with the risks of trading long on the stock market. If you have good reason to believe that a particular company's stock price will go down in value, you can make money by short-selling it.

Final Thoughts of Short Selling Stock

At the end of the day, short selling can be profitable if you know what you're doing.

Keep in mind that this type of trading provides an opportunity to make money when an investment thesis has failed, and some risks are involved.

In addition, always keep a close eye on stocks that have been hit hard by bad news, as they might just bounce back.

Short Selling Stocks FAQs

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.

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