What is ‘Shorting’ a Stock?

Written by nickel - 12 Comments

With all of the recent volatility in the stock market, I thought I’d talk a bit a bit about a turn of phrase — “shorting” a stock — that I’ve heard quite often over the past few weeks.

Shorting a stock (or executing a “short sale“) essentially involves borrowing shares of a stock such that you can sell them at today’s price. You then buy them back at some (hoepfully lower) future price point and pay back the borrowed shares. This is a relatively common (though potentially risky) technique that is used to make money in a falling market.

Think about it… Let’s say you believe that Company X is overvalued and set to take a tumble. If you borrow 100 shares and sell them at today’s market price (say, $10/share), you’ll pocket $1,000. If you were right, and the share price falls to, say, $6/share, you can buy back 100 shares for $600, resulting in a $400 profit (ignoring commissions and fees).

The downside is that the stock might go up, at which point you’ll have to buy the shares back for more than you sold them, resulting in a potentially substantial loss.

The real risk here is that the downside potential (and hence your gain) is limited — after all, a stock can’t fall below zero. But the upside potential is (theoretically) unlimited, meaning that you could take a beating if the share prices skyrocket.

Published on February 13th, 2008 - 12 Comments
Filed under: Saving & Investing
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Comments (scroll down to add your own):

Losing money on the short side of a trade is more difficult than one may think. Take a paper position of say $10,000. Trade only on the short side for, lets say 1 month. You will see how difficult it is to lose all your money. The point in this excerise is to try and lose all the money. It will teach a great lesson about investing the long side.
Comment by Lynn — Feb 13th 2008 @ 9:17 am
This is an interesting idea but why try to beat the market when you can just use the market to make money. The market is down, that means everything is on sale!
Comment by Saving Freak — Feb 13th 2008 @ 10:56 am
Or—

You could just short every stock I buy. Then you’re sure to make a fortune.
Comment by Ron@TheWisdomJournal — Feb 13th 2008 @ 11:38 am
A great concise explanation of the concept. I haven’t tried it yet, but I’m sure I will at some point.
Comment by Fiscal Musings — Feb 13th 2008 @ 11:48 am
You can also buy super short ETFs to hedge a portfolio. They are much easier and cheaper than shorting a bunch of stocks (i.e. you don’t have to have a margin account, etc.). Check out: http://www.proshares.com/funds
Comment by DD — Feb 13th 2008 @ 12:52 pm
Overall, it is a dangerous venture… The stock market has averaged about a 10% increase over the last 100 years, so the odds are already stacked against you right out of the gates. Sometimes, it can seem easy to pick when a company is doing something wrong, but there can be large consequences if you are incorrect. As you mention, the downside potential is not limited.
Comment by ChristianPF — Feb 13th 2008 @ 1:14 pm
If you want to limit your risk and SHORT you buy options…the OPTION to sell the stock back at a set price. The most you can lose is the cost of the options (I still haven’t done it yet but am interested). The main problem is I think you need a special upgraded account to trade options. Which is why I bought QID, like mentioned in comment#5, it’s a nice little ETF any stock trading account can buy that shorts the NASDAQ for you.
Comment by Luke — Feb 13th 2008 @ 1:16 pm
You need a margin account to play this game. Also, if the stock pays dividends while you’re shorting it, you have to pay the dividends to the broker you borrow it from.

@luke - you need an upgrade. It’s not hard to get. You would be buying naked put options or selling call options. I imagine that if you wanted to sell naked call option you would need to post some serious margin since it’s like leveraged shorting.
Comment by Early Retirement Extreme — Feb 13th 2008 @ 10:57 pm
When the MSM starts talking about the best short funds, the bottom is near and it’s time to buy.
Comment by mbhunter — Feb 14th 2008 @ 1:03 am
Great to know that,

Tracy Ho
wisdomgettingloaded
Comment by tracy ho — Feb 14th 2008 @ 3:04 am
Thanks Early, do you play that game?
Comment by Luke — Feb 15th 2008 @ 12:45 am
Have you ever shorted a stock?
Comment by John — Apr 6th 2008 @ 11:22 am