Reasons to short sell a share

Sometimes investors become convinced that a stock is more likely to fall in value than to rise. If so, investors can make money when the value of a stock goes down by using a strategy called short selling or shorting a stock. Also known as short selling a stock, short selling is designed to make you a profit if the share price of the stock you choose to short goes down – but can also lose you money if the share price goes up. It thus works like a reverse share purchase.

Why would you short a stock?

Usually, you may choose to short a stock because you feel it is overvalued or will decline for some reason. Because short selling involves borrowing shares that you don’t own and selling them, a fall in the share price will allow you to buy the shares back with less money than you originally received when you sold them.

However, there are some other situations where short selling a share can be useful. If you own a stock in a particular industry but want to hedge against an industry risk, short selling a competing stock in the same industry can help protect against losses. Shorting a stock may also be better from a tax perspective than selling your own holdings, especially if you anticipate a short-term downward movement in the stock price that is likely to reverse.

Reasons to short sell shares

1) If you are very good at it, you can make money over time. The list of people who have made money on the short side is getting smaller and smaller as this bull market continues, but there are some.

2) Every investor has a long “book”, but only a few short ones, so developing a well-articulated bearish thesis on a company or industry is a great way for a manager to make a name for themselves.

3) A short book usually pays off just when you need it most, during severe market downturns, providing the cash – and the psychological boost – to invest aggressively on the long side when it’s most attractive. It also improves yields

4) The psychological rewards are huge, especially for a value bettor, as short selling is much more contrarian than buying a stock that is not favored.

5) Even if you never shorted a stock, having the mindset of a short seller is very valuable: it helps develop healthy skepticism, knowing where to look for bombs on the balance sheet, and being able to value traps.

6) Being a blanker creates a flow of short ideas. You are not limited to just buying shares to make money. You can make a profit by selling shares you don’t own.

7) Finally, if you are running a hedge fund, many investors will have trouble paying your very high management fees unless you do some short selling that creates excess returns.

As these seven reasons show, short selling can make sense for some investors – but be careful! Don’t get sucked into it, as it can be an extremely costly activity where you are not well positioned to succeed.

How do you short sell a stock?

In order to use a short selling strategy, you need to go through a step-by-step process:

1. Identify the stock that you want to sell short.

2. Make sure you have a margin account with your broker and the necessary authorizations to open a short position in a stock.

3. Enter your sell order for the appropriate number of shares. When you send the order, the broker lends you the shares and sells them on the open market on your behalf.

4. At some point, you will need to close your short position by buying back the stock you originally sold and then returning the borrowed shares to the person who lent them via your brokerage firm.

5. If the price fell, you will pay less to replace the shares and keep the difference as your profit. If the price of the stock went up, it costs you more to buy back the shares, and you have to find the extra money from somewhere else and suffer a loss on your short position.

A simple example of a short selling strategy

Here’s how short selling can work in practice: Suppose you have identified a stock that is currently trading at $100 per share. You believe the stock is overvalued and you think its price is likely to fall in the near future. Consequently, you decide that you want to sell 100 shares of the stock that is, short it. You follow the process described in the previous section and initiate a short position.

When you sell the stock short, you get $10,000 in cash, minus whatever your broker charges you as commission. This money will be credited to your account in the same way as any other share sale, but you also have an obligation to pay back the borrowed shares at some point in the future.

Now let’s say the stock drops to $70 per share. Now you can close the short position by buying 100 shares at $70 each, which will cost you $7,000. You received $10,000 when you started the position, so you are left with $3,000. It represents your profit – again, minus transaction costs that your broker charged you in connection with the sale and purchase of the shares.

What are the risks of shorting a stock?

Keep in mind that the example in the previous section is what happens if the stock does what you think it will do, fall.

The main risk with short selling is that if the share price rises dramatically, you may have difficulty covering the losses. Theoretically, short selling can result in unlimited losses – after all, there is no upper limit to how high the share price can climb. Your broker will not require you to have an unlimited supply of cash to offset potential losses, but if you lose too much money, your broker may make a margin call – forcing you to close your short position by buying back the shares may prove to be the worst possible time.

In addition, short sellers sometimes have to deal with another situation that forces them to close their positions unexpectedly. If a stock is a popular target for short sellers, it can be difficult to find shares to borrow. If the shareholder lending the stock to the short seller wants those shares back, you must cover your short position. Your broker forces you to repurchase the shares before you want to.

Be careful with short selling

Short selling can be a lucrative way to make money if a stock drops in value, but it comes with great risk and should only be attempted by experienced investors. And even then, it should be used sparingly and only after a careful assessment of the risks involved.

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