Shorting a stock enables traders to try to capitalize on market declines.
The potential losses from short selling are limitless since there’s no cap on how high a stock’s price can rise.
Given the potential for large losses, traders need to be more disciplined about protecting their positions. Trading tools such as buy-stop orders can help.
One of the main reasons people invest is because stock markets have tended to rise over time. Since 1950, major U.S. stock indexes have generated positive returns in every decade save the 2000s.1
Even when the market is up, however, some individual stocks still suffer, laid low by bad management, a poor business plan, increased competition, new regulations or other factors. These are the stocks most investors try to avoid—most, but not all.
Unlike buy-and-hold investors, traders often try to participate in the market’s downs as well as its ups. Some traders even seek out stocks that appear poised for a decline and then attempt to profit from them. This strategy is called “short selling.” It is achieved by selling borrowed stock at today’s share price, purchasing the shares in the future when, as hoped, its price dips and pocketing the difference.
If the stock declines as expected, the trader will come out ahead. But if the stock rises instead, the trader could suffer significant losses.
How short selling works
You believe stock XYZ, which is trading at $25 a share, will decline significantly in the next week. You borrow 100 shares and then sell them for $2,500 ($25 x 100).
Scenario 1:Selling short works in your favor
Four days later, the stock has fallen to $20 per share. You decide to close your short sale by purchasing 100 shares to replace the ones you borrowed. You pay $2,000 for the new shares ($20 x 100).
Sale of borrowed shares: $2,500
Cost of purchased shares: –$2,000
Profit of $500
Scenario 2:Selling short works against you
Four days later, the stock has risen to $30 per share and appears to be headed higher. You decide to close your short sale by purchasing 100 shares to replace the ones you borrowed. You pay $3,000 for the new shares ($30 x 100).
Sale of borrowed shares: $2,500
Cost of purchased shares: –$3,000
Loss of –$500
These examples are hypothetical and do not account for dividend and interest payments, taxes, trade commissions or other fees or expenses that could reduce returns or increase losses.
Kevin Horner, Senior Manager, Trader Education, says the biggest risk of short selling is that there’s no ceiling to the price at which the stock could trade in the future.
When you’re long a stock—that is, when you buy it and hold it—and it drops to zero, the most you can lose is 100% of your investment. If you’re selling short, however, the stock price can theoretically keep on rising. That means your loss can exceed the amount you invested. “In essence, the risk of shorting is unlimited,” Kevin says.
Most traders would find the idea of unlimited losses off-putting, regardless of a trade’s profit potential. But sometimes even bullish traders might find occasion to short a stock. “I might take a bearish position if I feel like the market is taking a downturn and I’m not seeing opportunities to buy stocks,” Kevin says.
Even if you believe a stock is poised for a decline, however, there’s more to short selling than identifying a trade candidate. Given the potential for never-ending losses, “you have to be a lot more disciplined about protecting a short position than you do a long one,” Kevin says.
Here are three steps to consider before shorting a stock.
1. Identify a strong candidate to short
Kevin suggests using a screening tool to identify short candidates. “There are a number of approaches but one common method is to consider stocks falling through a series of lower lows combined with higher volume, which is indicative of a seller’s market. Kevin also searches for stocks that have rebounded from a clear downtrend in tandem with an overbought signal. “I look for stocks that have rallied to the upper range of the trading pattern and appear to be set to lose steam and fall again,” he says.
Even after identifying a candidate to short, Kevin waits to confirm a downtrend. “You cannot predict a move in the bearish direction, so some traders wait to get involved after it’s already moved lower,” he says. “Many traders are willing to miss the first 10% of a negative move and still hope to be profitable.”
2. Dig a little deeper
Shorting stocks involves some not-so-obvious risks that could add to your costs or make shorting a specific stock impractical. For instance, if the stock pays a dividend, the short seller may be responsible for paying it. This can add to the cost of a short sale and reduce the potential return from the trade.
Further, shares may be hard to borrow (HTB)—that is, difficult (or unavailable) to borrow. If you’re able to borrow a HTB stock, you’ll pay a fee.
Kevin also looks at the amount of “short interest” in a stock—that is, how many shares of stock have been sold short when considering a candidate. When there’s a relatively high level of short interest in a stock, any positive news can cause a spike in the stock price as traders hurry to buy shares to cover their short positions.
3. Have an exit strategy
It’s important to establish an exit strategy for your short position.
- A buy-stop order triggers a market order to buy the shares back if a trade price rises to or above the stop price entered.
- A trailing stop order is a conditional order that uses a trailing amount, designated in either points or percentages, to determine when to submit a market order. The trailing amount follows (or “trails”) a stock’s price as it moves up (for sell orders) or down (for buy orders). Once you submit a trailing stop order, it remains in force until it’s triggered by a specific change in the inside bid price (for sell orders) or the inside ask price (for buy orders). Once it’s triggered, it becomes a market order that’s submitted for immediate execution.
“When I short, I always have a stop order in place to help protect against a price spike,” Kevin says. “That way, if I’m wrong, the market will tell me right away.”
For example, Kevin says, “You could set your stop trigger prices so that your loss is limited to one-third of your profit target. This would mean that if your aim is to repurchase the shares $6 below where you sold them, you would set your stop price $2 higher than the stock is currently trading.
Of course, it’s unusual to get clear technical signals so traders must be nimble and adjust their trades accordingly. Also keep in mind that there’s no guarantee that a stop order will be executed near a stop price.
Be prepared to get it wrong
It’s impossible to eliminate all short-selling risks. Traders should be prepared to be wrong more than they’re right, and should build in exit strategies for this eventuality.
“With short selling, being disciplined is very important,” Kevin says. “Planning ahead may help to reduce potential losses when you’re wrong.”
Short selling at Schwab
In order to short a stock, you must be able to borrow shares of that stock in a margin account.2 To find out about adding margin to your account, call 866-663-5250 to speak to a Schwab Margin Specialist.
Once approved, the amount you can borrow depends upon the type and value of securities in your account.
- To begin borrowing at Schwab, you must have at least $2,000 in cash or marginable securities3 in your account.
- The amount of money you can borrow on margin is typically limited to 50% of the sale proceeds in the account prior to a trade's settlement. For example, if you sold short 100 shares of a $20 stock, for $2,000, you'd need to have $1,000 in your margin account at that time. It's also important to know that you'll be charged interest on the value of the stocks you borrow in a short sale.
- After the sale is settled, you need to keep enough cash or securities in your margin account to cover at least 30% of the stock's market value. For example:
If the stock stays at $20/share:
$20 x 100 shares = $2,000
$2,000 x 30% = $600 needed in margin account
If the stock rises to $40/share:
$40 x 100 = $4,000
$4,000 x 30% = $1,200 needed in margin account
1Federal Reserve Bank of St. Louis FRED database, as of 6/15/2016.
2Short selling is not permitted in retirement accounts.
3Not all securities are marginable.