What is short selling - What is shorting a stock?

Last updated: 28.02.2023
Dominic Hawker
Author:
Dominic Hawker
Adviser
CFD & Trading
Experience
> 30 years

Short selling has arguably never been more prevalent than it has in recent months due to the Gamestop frenzy. With that, more and more people are looking to find out more about what short selling is and how to short stocks themselves. 

Short selling is a tactic that should only really be used by experienced traders. The trading strategy can be lucrative but it comes with its own set of significant risks as well. The trick is finding the balance in your trade and knowing when you should cash your chips in and close the position.

Trade now commission-free

nextmarkets investors

  • What is short selling and how does it work?
  • A short selling example
  • Advantages of short selling
  • The costs of holding a short position
  • Risks of short selling
  • Tips for short selling
  • Conclusion

What is short selling and how does it work?

There are a number of different approaches to making money off the stock market, some are a more safe bet while others have a significant degree of risk attached to them. In the case of short selling, or shorting a stock, you will encounter a fair degree of risk. Before we move on to the risks vs rewards of short selling, let’s try to better answer the question, “what is short selling?” so you can better understand the short selling meaning in full.

If you are a trader, then short selling is essentially the speculation on the market value of certain stocks. You don’t need to be a financial guru to read the signs and understand the current lay of the land but short selling is definitely not for the novice trader. The idea is that you borrow a certain amount of shares of a stock or asset from the broker you are using. This is how you open your position. You do so with the hope that these stocks will decrease in value by the time you close your position on the trade.

Before you can close your position there are a few key steps that happen before you do so. You first need to sell the borrowed shares that you have taken from your broker. This shouldn’t be too difficult when using their platform. Before you have to return your borrowed shares to the broker at the agreed upon time, you are banking on the fact that the shares will have decreased in value by that time. You will then buy back these borrowed shares at a lower market value, thereby making a profit and closing out your position.

There are a few more key aspects to keep in mind like the account type you need, the costs involved and the risks and advantages. For now, let’s first take a closer look at a detailed example of short selling in a scenario where you make a profit and where you make a loss.

A short selling example

When it comes to understanding the question “what is short selling?”, you need to be wary of the possibility of making a loss but when done correctly you can also walk away with a nice little profit as well. Let’s take a look at either side of the spectrum when closing out your short position.

Making a profit

Let’s say for this example that you want to buy Facebook stock which is currently valued at around $310 per share. For the sake of simplicity let’s say you decide to borrow 10 Facebook shares from your broker. You then sell those 10 shares to another trader. You are now short 10 shares, shares that you never owned to begin with but rather borrowed from your broker. Everything goes to plan in the coming weeks and Facebook’s market value drops to $210 per share. You then decide that you are going to close the trade so you buy back the 10 shares that you borrowed from the broker at the new market price. You are now essentially replacing the shares that you borrowed from the broker with the shares you just bought at the new, much lower, Facebook stock price. 

So, your net profit from short selling Facebook stock is $1,000 at the close of your short position. In a simple sum, $310 – $210 = $100, $100 x 10 = $1,000. Easy right? That’s really all there is to it when it comes to conducting a successful short trade. 

Making a loss

Now that you have seen what a successful shorting position looks like, it’s important that you understand what the flipside of a trade like this looks like. This is a good example of why sometimes it’s better to cash in your chips then it is to hold out for more. You decide to buy Netflix stock which is valued at roughly $530. You then borrow 10 shares from your broker and sell it to another trader. The value of Netflix stocks then drops to $400 but instead of buying back the shares and closing your short position, you decide you want to hold and see if the price continues to nose dive. 

You wake up the next morning to find that the Netflix stock has taken a major upturn as the dip was only temporary. Netflix stock is now valued $600 and doesn’t appear to be stopping. You decide that it’s time to close your position as you don’t want to take a bigger loss. Your net loss on the trade would then be $700. Put simply, $530 – $600 = $70, $70 x 10 = $700. Making a loss on a short trade is not uncommon and your losses can theoretically be infinite. That is why it is so important to understand the risks of sucha  trading strategy but we will touch on that in more detail in the guide.

nextmarkets best CFD broker

Advantages of short selling

There are a couple of reasons why your more experienced traders like to use short selling as a trading strategy. Let’s take a look at a few advantages of the trading strategy:

Potential for large gains, with minimal investment: this is arguably where short selling has its biggest advantage. The potential profits are not infinite but the amount of capital needed to open a short position with your margin account is minimal. Using margin provides the trader with leverage. When done in the right way, shorting can be a cheap way for a trader to make a strong return on investment. 

Hedge your existing portfolio: you can hedge your position on a short by going long with a separate trade. Or, if you already own the stock you then don’t need to borrow shares from the broker but rather short the stock you already own to make a profit as the market value of the stocks take a downturn. Shorting is a great way to protect your profits or to limit your losses but it can become quite expensive.

The costs of holding a short position

Like many trading strategies, you are going to run into a few costs when it comes to opening a short position. These costs can vary but always boil down to stock borrowing costs, dividends and margin interest.

Stock borrowing costs

You will often find that stock you are trying to short may already be on the hard-to-borrow list on nextmarkets. This is because there are only a finite amount of shares left to borrow. It could also be that the stock price is highly volatile. Whatever the case may be you’ll be able to see if a certain stock is on the list of stocks that are in short supply.

The fees you have to pay on this limited stock can vary greatly depending on a number of factors. Essentially, the fee is a yearly rate that will be calculated based on how many days you have held your position open for. The fee amount can vary significantly but is generally calculated at the end of each month or at the close of your short position. 

Margin interest rate

If you are looking to use a shorting trade strategy you will have to be approved for a margin account. This means you will have to pay margin interest rates on your trade. This will vary depending on how long you hold your position for. Aside from the interest rates, you will also need to front 50% of your margin short trade. Basically, if you borrow 10 shares at $20 a piece you will need to fund your margin account with at least $100. This provides the broker with collateral to make sure you can cover your position at the end of the trade. 

Dividends

While you may technically be borrowing shares from a broker to take up a short position, you are still responsible for paying the dividend payments on the shorted stock. There is no way around this unfortunately. Dividend payment can stack up depending on how long you keep your short position open so it’s a good idea to keep this in mind if you have an idea of how long you plan to hold your position open for.

There are a number of risks involved with shorting strategy which is why we recommend that only experienced traders take this strategy on. New traders should generally avoid shorting until they have a better understanding of overall trade practices. Let’s check out some of the risks involved with shorting:

Risks of short selling

Potential for severe losses: shorting can bring with it significant losses. There is a limit to the amount that you can make as profit but there is no limit to the amount that you can lose. Theoretically, the amount can be infinite if you hold your position open. This is why it is a good idea to set stop loss orders when it comes to shorting a stock. This will limit the amount you can lose from the overall trade. 

Limited supply of stock: generally speaking, if you are shorting a stock then other traders are likely jumping on that bandwagon as well. This means that you may have difficulty locating enough shares to buy to close out your short position. This can mean greater losses. 

You’ll be trading against the grain: for the most part, stocks will rise, even if only by a small amount due to inflation. This means that when you are shorting, you are going against the general direction of most other traders. You are betting as the underdog which is why shorting requires time and effort. You need to do significant research to speculate with enough substance on the price movements of certain stocks.

Tips for short selling

There are a couple of things for you to keep in mind before opening a short position. These tips will hopefully help you on your way to some solid trades.

Timing is everything

Short selling is not just betting against a stock and hoping that by the time you close the position that a stock’s value has plummeted. Of course you need these things to happen but you want to know that they are going to. That is why timing is everything. A company’s stock may be overvalued but it may yet take a decent amount of time before you see the stock price take a downturn.

If you open your position too soon, you’ll be paying your margin interest rates until you see the movements you were hoping for. Whether you are trying to buy Google stock or trying to buy Apple stock, be sure to analyze the overall picture and try to time when you open your position to mitigate the costs you will have to pay. 

Always set your stop-loss order

What should be clear by now is that short selling can be risky business. You don’t want to hold your position open for too long if the stock is on an upward trend and you have to ultimately cover your position with an excessive amount. That is why it is a good idea to set a stop-loss order to make sure that the amount you need to pay to cover your position is limited to something you are comfortable paying. You don’t need to take severe losses, just make sure you are prepared to close the trade.

Conclusion

Short selling can be a tricky trading strategy to use and it can never truly be mastered as stocks can fluctuate on a whim. With that being said, shorting can lead to lucrative profits when done correctly and with enough research and analysis behind it. Hopefully after reading our guide you can more confidently answer the question “what is short selling?”

Keep in mind that short selling is not for novice traders despite what you may have seen in the news in recent months. If you are new to the trading world it’s best to steer clear of this trading strategy for now. 

If short selling doesn’t sound like it’s going to be for you then we can show you some of the best stocks to buy as well. We can even show you how to buy Tesla stock or how to buy Amazon stock as well. Check out the rest of our nextmarkets site to find out more.

Short selling guide FAQ

❓ What is short selling?

New trading strategies always have a few growing pains but they don’t need to be excessively difficult for you to learn and successfully implement. Our guide on short selling will help you to better understand the fundamentals of the trading strategy so you can better answer the question “what is short selling?”. You’ll know exactly what short selling is all about by the time you have finished reading our guide.

📊 How do I know what stocks to short?

Once you have a better grasp on what sort trading is and how it works you will need to start picking a few stocks to use with the strategy. Just leading any trading technique you will need to pick the right stocks that are going to complement the trading strategy itself. Our guide will help you to better understand where you should be looking and how you can come to your final decision about picking the right stocks for a shorting trade strategy.

💰 Is it expensive to keep a short position open?

There are a couple of different costs and payments involved when keeping a short trade position open. These costs can vary based on a number of different influencing factors. Our guide gives you a closer look at what some of these factors are and what some of the costs are that you can expect to pay when keeping your short trade position open. We leave no stone unturned as we give you a clear and decisive look at short selling.

Smarter Trading
  • Trade with Europe's commission free online broker
  • Receive up to 200 professional analyses per month
  • Trade more then 8000 shares, ETFs and other products
Start trading now
x