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Demystifying Short Selling

A common saying on Wall Street is “The bulls ride the escalator and the bears ride the elevator”—meaning that markets often decline faster than they rise.

Traders can take advantage of a market decline, and attempt to profit, by using a trading strategy called “short selling.” Let’s take a look at how short selling works, the risks involved, and the process of executing a short sale using tools provided on Schwab.com and in StreetSmart Edge®.

What is short selling?

When you think of investing, chances are you think, “buy low, hold for long period of time, and sell high,” which is a common strategy and is referred to as buying long.

When you sell short, the sequence is reversed: You identify a stock that you think will decline. Then, you borrow the stock from your brokerage firm and sell it short with the expectation of buying it back later at a lower price; thereby, realizing a profit.

Short selling mechanics

To sell short you must have a margin account with your brokerage firm, which is an account that allows you to borrow stocks using your own eligible securities as collateral. Selling the borrowed stock, or “selling short,” leaves a negative share balance in your account called a "short position." (Short sales are marked as “short” on the order entry ticket to distinguish short-sold shares from long-sold shares. See images below.)

Short selling example in Schwab’s All-In-One Trade Ticket.>

Source: All-In-One Trade Ticket, Schwab.com

Short selling example in Schwab’s StreetSmart Edge trading platform

Source: StreetSmart Edge

To close out (buy back) a short position or “buy to cover,” you would simply buy shares of the stock. There's no distinction between buying to cover a short position and buying to initiate a new long position.

Short selling risks

It's important to understand the risks of short selling. The most obvious risk is that the stock rises instead of declines, which forces the trader to buy it back at a higher price than initiated, thereby resulting in a loss of capital. On the surface, this seems no different than buying the stock with the expectation that it will rise, only to see it decline. However, with short selling there's a catch—your risk is unlimited.

Let me explain. If you’re long a stock that declines to zero, the most you can lose is 100 percent of your investment. If you are short a stock, the stock price can theoretically rise an unlimited amount, potentially resulting in more than a 100 percent loss.

Now let's turn our attention to the not-so-obvious risks of short selling:

  • Hard-to-borrow: In some cases, shares are either unavailable to borrow or hard-to-borrow. If a stock is hard-to-borrow due to limited availability, a trader will have to pay a hard-to-borrow fee that affects the probability of the trade  
  • Forced buy-in: Another not-so-obvious risk is that once shares have been borrowed and a short sale has been initiated, a trader can receive a "forced buy-in." This means that an owner of the borrowed shares through the margin account wishes to sell them, or the shares are otherwise no longer available to borrow, and no other shares are available to lend. The trader who shorted the borrowed shares is then forced to buy those shares back and cover their short position so that the original owner is not inconvenienced. The short seller has no control over this event and it may occur at any time.
  • Dividends: Additionally, if the stock pays a dividend, the short seller is responsible for paying the dividend, which adds to the cost of a short sale and reduces the potential return.
     

Short selling process

Trading can be viewed as a four-step process:

1. Screen: Look for new companies to consider
2. Research: Analyze the companies using both fundamental and technical analysis
3. Execute: Plan and enter the order
4. Monitor: Once executed, evaluate if the trade is still valid and adjust your strategy as needed

You can also apply this process to short selling, but you'll be looking for companies possessing the opposite characteristics of those you’d want to buy long. When you screen for new short sale candidates, consider looking for companies with poor and deteriorating business fundamentals and stocks in confirmed downtrends.

As you research these companies with an eye toward short selling, confirm that the characteristics spotted in the screen are, in fact, negative. You can use StreetSmart Edge's tools to help you with this step.

Then, before you execute, identify entry points, price targets for potential profit, and most importantly—stop-loss points for exit. Ensure the stop-loss exit is above your entry price and your price target is below. Be mindful that the stock in question can potentially rise much more than it can potentially decline. 

As you monitor the executed short sell, watch for any change back to an uptrend.

Short selling in action: StreetSmart Edge tools

Let's take a more in-depth look at the second step in the short sell process—research. StreetSmart Edge's tools can help you quickly evaluate both fundamental and technical data.

When you click on the Launch Tools button below, you can see a list of the tools in StreetSmart Edge.

Schwab StreetSmart Edge Trading Tools for Short Selling Example

Source: StreetSmart Edge

Here, we'll look at the Research and Chart tools to help you understand the fundamental picture of a company and the technical prospects of its stock.

Schwab StreetSmart Edge Trading Tools for Short Selling Example

Securities, symbols, and market data are shown for illustrative purposes only, and should not be construed as offers to sell or solicitations of offers to purchase any security.
Source: StreetSmart Edge

Let's first review the Research tool, which can help us evaluate how a company is performing as a business—often referred to as fundamental analysis.

Look at the fundamental metrics 

While there are many metrics used in fundamental analysis, perhaps one of the most important is the earnings per share (EPS) growth. It’s likely that a stock's price will move in the same direction as the company's EPS—higher or lower. A closely related fundamental metric is, "sales growth over the past year and/or quarter." When looking for short sale candidates, traders often consider companies with negative EPS growth and sales growth rates.

As an example, we’ll look at fundamental metrics for the hypothetical XYZ Corp. (on the Metrics tab of the Research tool, shown below.

As you can see, EPS growth (yoy) and annual sales growth (yoy) have declined by over 22%, and quarterly sales (yoy) have declined by 69%.These are the attributes of a potential short sale candidate; however, before placing the order, we need to evaluate the trend in price, which is part of technical analysis.

Schwab StreetSmart Edge Fundamental Analysis Metrics for Short Selling Example

Partial screenshot of Metrics tab
Source: StreetSmart Edge

While fundamental analysis looks at the business performance of the company, technical analysis can help evaluate how the stock is performing. Even if the fundamentals are poor, the stock could still be in an uptrend, especially in a bull market. Selling short into an uptrend is exactly the same problem as buying a stock that is in a downtrend—fighting the trend!

Another common problem that can make short selling more difficult is when the stock has already declined significantly. In this case, because the stock can only fall to zero, much of the move may have already happened. Remember, a stock will often limp along at low prices for years before it goes to zero.

The best time to place a short sale is early in the downtrend, which tends to be sharper and steeper than an uptrend. And if you miss the early part of the move after the trend changes, your best bet may be to avoid a short sale. Remember, "Bears ride the elevator."

In the example shown in the chart below, the stock dropped, but then rallied back to $46 before resuming its downtrend. Using this example, let’s say your research suggests that you should enter a short only if the stock falls below $42, and you want to exit should your loss exceed $2.00. A short sale could be entered upon a break below $42, but you would want to make sure that the stock is moving lower. If the stock were to rise back above $44, then the uptrend has probably resumed and it would be time to exit the trade. In this case, you would enter $44 as a buy stop. (Note that if the stock gaps higher than $44, your stop would be executed at the next available price, which could be far from $44). In this case, you have done everything in your power to limit the potential loss to $2.  

Using the recent low as potential support and an initial target, shown below at about $38, you would be attempting to limit risk $2 to potentially make $4. At $38 one might consider taking partial profits, while holding part of the position given the possibility to move even lower.

Look at the trend.

Schwab StreetSmart Edge Trading Tools for Short Selling Example 2

Source: StreetSmart Edge

Bottom line

Short selling can be an interesting way to potentially profit in declining markets, but it's important to know the risks. As traders get more comfortable with this strategy, it also may help their ability to identify changes in stock trends.

What You Can Do Next

Short Selling: Is It Right for You?
What Is Short Selling?
WashingtonWise Investor

Important Disclosures:

Short selling is an advanced trading strategy involving potentially unlimited risks, and must be done in a margin account. Margin trading increases your level of market risk. For more information please refer to your account agreement and the Margin Risk Disclosure Statement.

There is no guarantee that execution of a stop order will be at or near the stop price.

Schwab does not recommend the use of technical analysis as a sole means of investment research. 

The information here is for general informational purposes only and should not be considered an individualized recommendation or endorsement of any particular security, chart pattern or investment strategy.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Past performance is no guarantee of future results.

(0419-99T6)

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