Short Selling: Can You Profit from Falling Stocks?

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Narrator: Short selling, or shorting, is one way experienced traders with a margin account can attempt to profit from falling asset prices. It involves borrowing shares of a stock from your broker and selling them at one price, and then buying the shares back later at a hopefully lower price and pocketing the difference.

The idea of profiting by selling something you don't own may seem counterintuitive, so let's start with a simple example. After doing research, you believe a stock's price is going to drop, so you place an order to short 100 shares of the stock, which is trading at $100.

We'll get into where those 100 shares come from in a minute. For now, just assume the broker lends you the shares, you sell them, and you collect $10,000.

After a few weeks, the stock falls to $90, and you decide to cover the short position, which means you buy back the shares and return them to your broker. You buy-to-cover 100 shares at $90 for a total of $9,000. You keep the $1,000 difference between the sell price and the buy price, minus any transaction costs.

That's an example of a good outcome, but what happens if the stock goes up? If the stock rallies from $100 to $110 and you decide to close the position, you'd buy back the shares for $11,000, a loss of $1,000. If you don't close out of the losing short trade, your risk is technically unlimited because the stock could continue to rally.

You may wonder who's on the other side of a short sale: where do the shares come from, and why would somebody hold on to shares of a stock they expect to fall? When your broker loans you shares for a short sale, they may come from the brokerage's own inventory, another investor, or from a third party like a fund.

These other investors may be holding the stock because they have a different outlook on the stock's potential. Or in the case of an index fund, they may be required to hold the shares and choose to lend them out to generate revenue. Keep in mind, not all stocks are available for short selling.

Now that we've covered how shorting works, let's look at some risks that come with shorting a stock.

The first risk stems from using margin. To short a stock, you need a margin account, which allows you to borrow shares and borrow against your own investments.

Let's walk through an example. Once you short the shares, your broker will place the proceeds in your account, where they are set aside until you buy back the shares to close the position. This is known as the "short balance". At the end of each trading day, a settlement takes place, and the short balance changes based on how much the stock price moves based on that day's closing price.

If the stock drops as expected, then money is swept out of the short balance, added to the "cash balance", and is then available to trade. However, the profit isn't realized until the position is closed.

If there's a loss on the trade, cash is swept out of your cash balance and into the short balance. If cash isn't available, then the account margin is used, leading to interest charges.

The trade moving against you could also result in a margin call. A margin call occurs when the account doesn't meet your brokerage's minimum equity requirements.

On-screen text: Disclosure: Not all securities are marginable. You can only transfer marginable securities if you're transferring securities into the account to meet a margin call.

Narrator: To meet the margin call, you have to deposit cash or securities or close positions to raise the equity in your account. The broker may close positions in your account without regard for profit or loss and typically reserves the right to do so without prior notice to you.

One way to try to avoid margin calls is by defining your exit signals when you enter the trade, so you know when to get out if things go wrong. You could also consider consolidating your accounts to more easily manage your investments and increase your available margin. And don't overleverage your account by using all of your available margin at once.

Another risk of shorting is that the lender can recall the shares at any moment. You can reduce this risk by shorting stocks classified as "easy-to-borrow", which have a lower risk of being recalled.

Easy-to-borrow stocks commonly have a high number of outstanding shares that are widely held by other investors and have fewer fellow short sellers. When looking at a trading platform, you'll often see ETB when shares are easy-to-borrow. If no designation appears, contact your broker.

A broker may also designate narrowly held stocks with fewer outstanding shares or more short sellers as "hard-to-borrow", or HTB.

HTB stocks that have available shares may come with a "short interest" or a "hard-to-borrow" charge. The short-interest charge is an extra fee associated with shorting. Unlike HTB stocks, easy-to-borrow stocks typically have no short interest.

Another risk of shorting stock comes from dividends. While shorting a stock, you don't collect its dividends. Instead, you're responsible for paying dividends to the stockholder.

Short selling can be a weapon in your bear market arsenal. However, if you hunt bears, it's good to protect yourself. Determine beforehand when you'll short, how much you'll short, and when you'll get out of the trade.

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