Shorting a stock, also known as “short selling” is when you bet a stock price will go down. It’s a little more complicated than just buying and selling a share, so let’s break down how shorting a stock works in three simple steps:

1. Borrow:

   The first step is to borrow shares of the stock you want to short from your broker. This is usually done behind the scenes.

2. Sell:

   Next, you sell the borrowed shares of stock at the current market price (and hope the price goes down). You receive the money from selling the stock, but are on the hook to your broker for the borrowed shares.

3. Buy Back:

   When you’re ready to close out your trade and close your position, you buy back the shares and return them to the broker. If the stock price went down, you would profit from the difference between the initial sale and the repurchase of the shares. If the stock price went up, you’d incur a loss from the difference between the initial sale and the repurchase.

Here’s an example:

John borrows 10 shares of company ABC from his broker.

He sells the borrowed shares at the current market price of $50, for a total of $500. John receives the $500 from selling 10 shares of stock, but still owes the broker 10 shares.

Let’s say the stock price drops to $40 a few months later. John can buy back 10 shares at $40 each, costing $400. He can return the 10 shares to his broker and pocket the difference of $100 ($500 - $400 = $100)

What if the stock price increases?

Now let’s say the stock price increases to $60. John would have to buy back 10 shares at $60 each, costing $600 (more than he originally sold the shares for). He would return the 10 shares to his broker and incur a loss of -$100 ($500 - $600 = -$100)

Risks

Like most things in investing, shorting a stock carries risk.

Unlimited Potential Losses

When you purchase a stock, the maximum amount of money you can lose is what you invested, or how much you paid for the stock. The lowest a stock price can ever go is $0.

On the other hand, when you short a stock, there is theoretically unlimited risk because there is no cap to how high a stocks price can go. If the price of a shorted stock skyrockets, you could face severe losses.

Margin Requirements

Brokers usually require a margin account for short selling, meaning you have to have collateral or pay interest on the borrowed shares. If the stock rises and your account falls below a certain level, your broker can issue a margin call, requiring you to add funds or close the position, potentially at a significant loss.

Short Squeeze

If a lot of investors short the same stock, a sudden increase in the stock price can cause a short squeeze. As prices rise, short sellers rush to cover their positions to limit losses, causing a further increase in the stock’s price. This cycle can lead to extreme price spikes, creating substantial losses for those who are short.

Conclusion

Personally, I don’t short stocks. Markets are wildly unpredictable, and I don’t want to get caught with my pants down and open myself up to unlimited losses. I prefer to buy and hold for the long-term.

Talk soon,

Darrell