What is short selling? And why is it risky?

Karl 29th Nov 2023 No Comments

Reading Time: 5 minutes

Short selling is a financial strategy where investors aim to make a handsome profit from struggling stocks. Yet despite the ‘get rich quick’ glamour often associated with short selling, borrowing stock to earn a profit is risky to say the least.

In this article, we’re going to explain short selling in more detail. Plus we’ll touch on how short selling works, and highlight the downsides to keep in mind.

Keep on reading for all the info or click on a link below to jump straight to a specific section….

What is short selling?

Short selling is a trading strategy where investors aim to profit from a fall in value of a particular asset, typically stocks.

In brief, short sellers will borrow stocks from a brokerage firm, and then wait for their value to fall before buying back the stock.

Short sellers are often referred to as ‘pessimistic investors’ given they essentially bet against a company’s success. This is why short selling is hugely different from the more conventional investing approach of ‘buying low and selling high’.

So why might investors choose to short sell?

Well, it’s worth knowing that profits of up to 100% are possible when shorting a stock – just ask any hedge fund manager! Also, short selling provides investors with an opportunity to earn juicy returns, even during a downturn.

For example, say an investor believes the tech industry is overvalued. In this scenario, a short seller may be inclined to ‘short’ a number of tech stocks. To do this, he or she will borrow tech stocks from an online broker in order to sell them. The investor will then buy them back after the stock has fallen. The difference between the value at the time of borrowing, and the value of the time of purchasing the stock will be the profit, minus fees.

It’s fair to say that short selling has earned itself a bad reputation as of late, much of which may be attributed to the semi-recent GameStop saga. However, contrary to popular belief short selling is legal, and may actually have a positive impact on markets.

This is because the actions of short sellers can help provide liquidity, contribute to overall market efficiency, and ensure stocks are fairly priced.

How does short selling work?

Now we’ve touch on what short selling is, here’s a quick step-by-step guide on how it works in practice…

Step 1. Identity a suitable stock.

It almost goes without saying, but if you want to be successful at shorting you’ll first need to identity a stock you feel is poised to decline in future. No easy feat of course, but doing your research, and using sound judgement will give you the best chance of success.

Step 2. Place a sell order.

Once you’ve identified a stock you feel is likely to fall, the next step is to borrow shares. To do this, you’ll need place an order to sell stock that you don’t own on a brokerage account. Once you’ve completed this step, your short position will likely be displayed on your account as a negative balance.

Do note that to short a stock ‘margin trading’ will need to be enabled on your brokerage account. Also note that anything you borrow will essentially be counted as a loan, so you’ll have to pay interest on this.

Short selling investors also face a ‘cost of borrow’ which is another fee to bear in mind – usually represented as a percentage of the stock borrowed. Any dividend payouts from your borrowed stock will also have to be accounted for.

Step 3. Wait for the stock to fall in price.

Once you’ve sold your shares, you’ll then need to play the waiting game. If and when the value of your shares fall it may be worth thinking about closing your position.

Step 4. Return your borrowed shares.

When you’re happy with the price of your shares, you may close your position. To do this, you simply need to buy the stock. Once done you’ll hopefully see your negative balance go into the green. The difference between the proceeds from your initial sale and the cost of repurchasing the shares represents your profit. Obviously, there are no guarantees here, and it’s possible for short sellers to lose out big (see the ‘risks’ section below).

What are the risks of short selling?

While short selling can be a lucrative strategy, it carries significant risk.

Unlike with ‘going long’ on traditional stock, where the potential loss is limited to the amount invested, short selling carries unlimited risk. That’s right, ‘unlimited’ risk. For example, if you short a stock and its price rises instead of falling, then you could be staring at a significant loss. The higher the rise, the bigger the pain!

This contrasts to regular investing whereby the maximum sum you can lose is the value of your original investment. For example, say you buy £100 worth of shares in ‘Company A’. In the worst case scenario, Company A will go to the wall and the value of your investment will fall to zero, leaving you with a £100 loss.

With short-selling, there is no such cap on losses. You only need to read up on the 2021 GameStop saga – where retail investors piled in to push up the price of its stock to spite short sellers – to understand the potential for devastating consequences for those gambling on stock price falls.

In short, the GameStop saga caused the price of the retailer’s stock to rise by more than $500, leading to a ‘short squeeze’ whereby its price rose (and rose!) due to short sellers clamoring to buy back the stock to limit losses. It was a textbook example of how things can go very wrong for short sellers!

Minimising risk

It should be noted that one way to minimise the risk of unlimited losses when short selling is to implement ‘stop-loss’ orders.

A stop-loss order is set at a specific price, and if the stock’s price reaches that level, the order is triggered and the position is automatically closed. This can help short sellers prevent larger losses should a stock price move in the wrong direction.

Another way to minimise risks when short selling is take on ‘long positions’ on related stocks or indices you’re shorting. For example, say you decide to short a UK-based blue-chip. To minimise the risk of huge losses, you might wish to invest in the FTSE 100 share index as a whole. That way, if your short sell turns out to be a disaster, the value of your FTSE 100 holdings would likely rise to compensate.

This is a very basic example of how to hedge a short sell, but hopefully you get the idea!

Short selling isn’t for everyone

Let’s be clear here, even if you’re comfortable with huge losses, the consequences of a short position going wrong can be financially devastating. This is one of the reasons why short selling is probably best suited to hedge funds, and/or those with huge amounts of capital.

If you do decide to short sell, then do seriously think about adding a stop loss to your order to prevent major losses.

If you’re interested in investing, but you think short selling is too risky, then it’s probably worth taking the time to to read up on how to put together a sound investing strategy, ideally one that aligns with your financial goals and tolerance for risk.

And remember, as with any type of investing, returns are never guaranteed. Before you invest, always do your own research and ensure you fully understand the risks.

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Disclaimer: When investing your capital is at risk. Remember, the value of any investment can both rise and fall. Always do your own research.

MoneyMagpie is not a licensed financial advisor. Information found here including opinions, commentary, suggestions or strategies are for informational, entertainment or educational purposes only. This should not be considered as financial advice. Anyone thinking of investing should conduct their own due diligence.

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What is short selling? And why is it risky?

What is short selling?