Shorting a stock means to sell shares which an investor does not own, but has temporarily borrowed. The investor expects that the stock is overvalued and its price will fall soon. Going short is the opposite of going long, in which the investor picks up stocks that seem to be undervalued. Here the investor expects the stocks to be worth more in the future.

How Shorting Works

Assume that A owns 20 shares of company X at $100 per share. B believes that the stock price of X is overvalued and is bound to crash soon. If B is convinced that X will crash, B goes to A, and borrows the 20 shares. A agrees to lend the shares under the assurance that B will return 20 shares of X at a future point.

If B sells the 20 borrowed shares at the market price of $100 per share, B earns $2000.

In three days assume X’s price crashes to $40 a share. B can now buy 20 shares of X for $800. B returns the 20 shares to A. Since B has bought the shares at a lower price, he makes a profit of $1200 ($2000 - $800).

If X’s value had risen, B would have been forced to buy back the shares at a higher price and absorb the loss. In regular investing your losses are limited to the amount you bring in. If you invest $1000 you cannot lose more than $1000. But with shorting, there is no limit to the amount you could lose if the stock rises further. Besides, you are paying interest for borrowing shares. If X’s price had risen to $500, B would have been forced to buy back the 20 shares at a cost of $10000. B would have lost $8000 ($10,000 - $2000) plus interest charges.

When do you short stock?

• Some investors engage in shorting stock as a hedge to protect their portfolio. A portfolio which includes both long and short positions in stocks which tend to move together is likely to be less volatile than one which has only long positions. If stock prices are falling, short positions help reduce the losses from long positions.
• During an economic downturn, shorting a stock can net you profits. The Securities and Exchange Commission banned short selling in stocks of financial institutions for a two-week period last September, the month when Wall Street crashed.
• You can short a stock even if its last trade was a downtick, which means the price was lower than that of the previous trade. Until 2007, you could only short a stock whose last trade was an uptick, in which the price was higher than that of the previous trade.

Pitfalls of shorting

• Short selling can expose investors to potentially unlimited risk, if the price of the stock keeps rising.
• If the markets are in recovery mode, shorting is likely to lead you to losses.
• You will be charged interest on the borrowed funds/shares as well as subject to several rules and regulations that govern shorting stock. You cannot short a penny stock, which trades at a relatively low price and has low market capitalization.
• To begin shorting stock, you must open a margin account with a brokerage firm. The Federal Reserve Board’s Regulation T makes it mandatory that 150% of the value of the position at the time the short is created be held in a margin account. This 150% includes the full value of the short (100%), and an additional margin requirement of 50% or half the value of the position. If you wanted to short a stock and the combined value was $10,000, you would be required to put in an additional $5000, along with the $10,000 from the short sale.
• Getting information is more difficult compared to taking long positions. Brokers and analysts tend to emphasize what to buy and not what to sell. The good news is more widely known than the bad news. Analysts who issue sell recommendation on a stock find it much harder to obtain information from the company.