How Does Shorting a Share Work?

Shorting shares generates profits from falling share prices.

Selling stock short, or shorting, is a stock market strategy to profit from falling share prices. Shorting stock can earn a trader significant profits when share prices are falling, but there are several traps the trader must be aware of and avoid. Short selling has its own set of rules, and the trader must have the appropriate type of account.

Function

Shorting a stock involves borrowing stock you do not own, selling it at the current market price, and buying it back at a lower price after the shares fall in value. The profit is the difference between the selling price of the stock and the price paid to purchase the shares back. Short selling can only be accomplished through a margin account with a stock broker.

Features

To short a stock, a trader enters a sell to open trade with his broker. The short sell trade cannot be completed unless the shares are available to borrow. The broker will loan the shares from their own inventory or borrow the shares from another investor's account that owns the shares. Once the broker determines the shares are available, the short sale is filled at the current market price. The proceeds from the sale are held in the trader's account but restricted from any other use or withdrawal.

Requirements

The trader who sells short must put up at least half of the short sale value as a margin deposit. For example, a trader shorts 100 shares of a $50 stock. The $5,000 from the sale of sale of the stock will be restricted on the trader's account and an additional $2,500 margin deposit will also secure the trade. This money is committed to the trade until the shares are purchased back to close the trade.

Potential

To realize the profit of a short sale, the trader must enter a buy to close order and buy the stock back. The profit or loss will be the difference between the price when sold and purchased back. If our trader can buy to close to trade listed above at $40 per share, the profit will be $10 per share or $1,000 on a 100-share trade. If the stock had risen to $60 when the short sale was closed, the trader would have lost $1,000. The maximum profit a trader can earn on a short sale is the total initial cost of the stock if the stock goes to zero. The theoretical maximum loss is unlimited because a stock price can rise indefinitely.

Warning

There are several negative consequences of selling stock short. If the stock pays any dividends while the trader is short, she must pay the dividend amount to the shareholder. The biggest risk is the short squeeze. A short squeeze happens when traders have a large percentage of a company's stock sold short and the share price starts to rise. The short sellers enter buy trades to close their positions, pushing the price higher. As the price moves up, more short sellers attempt to buy to close, further pushing the price higher. A short squeeze can cause a stock price to increase very rapidly, causing very large losses to short selling traders.

References

• Investopedia: What is Short Selling?
• The Street: How Short Selling Works