Short Selling 101 – What is it, Examples and Alternatives

Last Updated: June 4, 2019
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Short selling is a risky business and not ideal for the average investor. However, it can be a great tool for professionals. In this article, we review the basics of short selling - how does it work, what's the main things to consider and of course, the risks.

The Smart Investor content is intended to be used and must be used for informational purposes only. We are not an investment advisor and you should NOT rely on this information to make investment decisions.

Have you heard of short selling and short sellers? Maybe you have read on the media that they are speculators and manipulators and they “distort” the market. This is not entirely true since all players influence the market as well as each other’s performance.

What is short selling, however? How does it happen and what is the mechanism of it? Is it appropriate for you or not? Are there any alternatives to it? I will answer all these questions in this article.

What is Short Selling?

Of course, short selling is not an easy job. Simply put, short selling is the process of selling securities which an investor doesn’t own. Sounds strange?

The logic behind it is not, though. Short sellers sell something at a high price because they believe that in the future they can buy it back at a lower price, thus making some profit. How do you sell something you don’t have?

Well, loans, remember? You actually borrow a security from a person or a company that owns it. Just like in loans, you need to pay interest because you use someone else’s stocks. Short sellers pay fees to the owners. What will happen if the price goes up when a short seller sells the stock instead of going down as planned?

In such a case, you will have to pay additional money to buy the stocks at a higher price than you borrowed it. Therefore, the amount of profit a short seller can make is the difference between the two prices: the sale price and the purchase price.

Keep in mind – short selling is riskier than the normal way of investing in stocks.

If an investor purchases some stocks all they can lose is the value of these stocks. But when you borrow something and you pay fees and eventually the value of the stocks plummets, you can be a big time loser.

Example of Short Selling

Still cannot get the idea? Well, let me give you one easy to understand example.

John wants to try short selling. He goes to Adam and wants to borrow from his stocks which currently trade at 50$ apiece. Adam agrees to lend him 1000 shares at 50$. For that, John has to pay a fee because he uses someone else’s assets.

Why does John want so eagerly to short sell? Let’s imagine he has been doing research for 6 months and he’s estimated that the mentioned stock will lose its value in the next month. In his trading account, John has 1000 stocks each at 50$. He sells them and receives $50,000. Part of this money will be kept as collateral (protection against losses). After the sale, there are two possible scenarios:

1) The price of this stock does indeed fall in the next month to 35$ per share. John, therefore, buys back all the 1000 shares and pays for that 35,000$. His gross profit is the difference between the prices – 15,000$. Gross is not net, you know. He has to pay fees and other costs.

2) The price of the stock goes up to 60$ per share. The amount you have to pay for buying these stocks is 60,000$ meaning that John has generated 10,000$ of losses.

ScenarioRevenueProfit
35$ per share35,000$-15,000$
60$ per share60,000$+10,000$

The amounts of profit or losses in the example are gross. Keep in mind, anyone dealing with buying or selling stocks will have to pay various fees, costs and commissions along the way.

How Do You Sell a Stock You Don’t Possess?

You already know the short answer to this question: you have to borrow these stocks from someone who’s willing to do so. The process is actually not so difficult. Once an investor agrees to lend you their stocks, they will relocate their shares to your account. But why would anyone agree to do that?

It’s all about business. If you are trustworthy, an investor will lend you their shares because you will pay them an interest on the “loan”.

Number of Short Positions As an Indicator

Knowing is essential and you have to be ready to check out info on stocks and short-selling positions every day if you want to make it big. Where can you find this? The simplest way to do it is to use a reliable source of information – Yahoo Finance. Choose a stock and under the “Share Statistics” section you can find the following info:

1. The number of shorted shares – it shows the number of the shares which were shorted and should be the same as the number on Nasdaq.

2. Short ratio – we also call this ratio “days to cover” and we calculate it by dividing the number shorted shares by the average trading volume.
3. Short positions related to the float – this indicator is a percentage, and it shows how the number of shorted shares relates to the float. The float is the actual number of stocks which investors can trade. This indicator is very important. If this indicator shows 100%, it means that all the stocks belonging to a company have been sold.

4. Number of shorted shares in the previous month

What is a Short Squeeze?

Simply said, this is a situation in which a short seller would never want to be. Sometimes, due to various reasons and factors, a stock’s price starts rising. As you already know, this is very bad news for short sellers. They, of course, start closing their short positions hoping to mitigate losses.

By doing so, they add up extra pressure and the price goes ever so higher. This is what we call a short squeeze. Overall, this is one of the main risks associated with short selling.

Can short sellers manipulate the market?

This is a question that has many answers. Yes, no, a little bit. Of course, many companies and investors claim that short sellers actually manipulate the market so that they can make huge profits. But isn’t that the market itself? Anyone is trying to “manipulate” something so that they can earn more. Didn’t Volskwagen some two-three years ago try to lie to the public about their diesel cars and the emissions they release? They did and they admitted to doing so.

All countries have laws and authorities which determine what is legal and what illegal. They will be after anyone who violates the rules, whether it’s a normal investor, a short seller or a big player like Volskwagen.

Short selling is for experienced traders.

There are two main types of accounts: cash and margin accounts. The former are accounts where the broker wants the investor to pay for the securities. The latter are accounts in which the broker lends the securities to the borrower. Having said that, if you want to short sell you need to have a margin account. Cash accounts do not allow their owners to short sell.

I’d recommend everyone who wants to become a trader first to open a demo cash account and get to know the basics of day trading. If you are a rookie and jump into the deep waters of short selling, it’s possible that you will lose a lot of money since the potential for that is limitless. Definitely, short selling is for experienced pros who know the ups and downs of this process.

What are The Alternatives to Short Selling?

Maybe short selling is not the thing for you? Are there any other ways an investor can benefit from the falling prices of a stock? Let’s look at some of the alternatives to shorting:

  1.    Stock Futures

Stock futures are futures contracts and work in a similar fashion. A future is a contract between a buyer and a seller in which one of them should buy or sell an asset at a predetermined price at a specific moment in the future. These financial instruments are usually used by experienced traders.

  2.   Put options

Put options, just like futures, are contracts between a buyer and a seller in which you can sell the shares at a preliminary agreed priced at a specified time. This is not obligatory, only if the seller wants to do so. All you need to pay is a premium. If the price of the stock is below the agreed price on the day the contract expires, you can make a good profit. If it is higher, then you will lose only the premium

  3.   Inverse ETFs

These are exchange-traded funds which track a sector index in reverse. If the underlying index goes down, the ETF will go in the opposite direction – up. Here you don’t trade on margin. ETFs track whole sectors through the respective index, which means that you cannot trade single stocks.

Bottom Line

All in all, short selling is a great financial tool. I’d recommend it to people who have advanced knowledge of the market as well as experience in trading. This will not only guarantee successful and profitable trading but also help you mitigate the potential losses (which are unlimited).

If you want to capitalize on falling prices and you don’t feel like short selling is your game, you can always try other things, such as inverse ETFs, put options and futures.

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