Introduction to Short Selling

Short selling allows investors to profit from declining stock prices. While it's a powerful strategy, it carries significant risks that every investor should understand. [DEFINITION] Short Selling: A trading strategy where you borrow shares from a broker, sell them immediately, and hope to buy them back later at a lower price to return to the lender, pocketing the difference. ### How Short Selling Works 1. You believe a stock will decline 2. You borrow shares from your broker 3. You sell the borrowed shares at the current price 4. Later, you buy shares to return to the lender 5. If the price dropped, you profit; if it rose, you lose [EXAMPLE] You short 100 shares of XYZ at $50 (receiving $5,000). The stock falls to $35. You buy 100 shares for $3,500 to close your short. Profit: $5,000 - $3,500 = $1,500 (minus borrowing costs). [FORMULA] Short Profit/Loss = (Selling Price - Buying Price) × Shares - Borrowing Costs ### The Risks of Short Selling **Unlimited loss potential:** When you buy a stock, the maximum loss is 100% (it goes to zero). When you short, losses are theoretically unlimited—a stock can rise infinitely. [SCENARIO] You short a stock at $50. It gets acquired at $120. Your loss is $70 per share (140% loss). This is why short selling is dangerous. **Other risks:** - **Margin calls:** If the stock rises, you may need to add money - **Borrowing costs:** You pay fees to borrow shares - **Short squeezes:** Rapid price increases force shorts to cover, accelerating gains - **Dividends:** You must pay dividends on borrowed shares [WARNING] The GameStop short squeeze of 2021 bankrupted hedge funds. A stock shorted at $20 rose to $483. Short sellers lost billions in days. Short selling can ruin you quickly. [KEY] Short selling is a zero-sum game with asymmetric risk. While stocks can only fall 100%, they can rise 200%, 500%, or more. The odds are structurally against short sellers over time. ### When Shorting Might Make Sense - **Hedging:** Protecting a long portfolio against declines - **Pair trades:** Long one stock, short a weaker competitor - **Clear fundamental problems:** Fraud, obsolete business model - **Technical breakdowns:** Confirmed downtrends [TIP] Most investors should avoid short selling. If you believe a stock will decline, simply not owning it (or selling if you own it) avoids the unlimited risk of shorting. [EXERCISE] You short 50 shares at $80. The stock rises to $100 and you're forced to cover. What is your loss? |ANSWER| Loss = ($100 - $80) × 50 shares = $1,000 (plus any borrowing costs). You sold at $80 and had to buy back at $100, losing $20 per share. ### Short Interest as an Indicator Short interest (percentage of shares sold short) can indicate: - High short interest: Many believe the stock will fall - Short squeeze potential: If stock rises, shorts may be forced to buy - Contrarian opportunity: Sometimes heavily shorted stocks are actually undervalued