The Risks and Rewards of Short Selling a Stock: A Closer Look at the Practice of Trading Short

What is Short Selling of Stocks and How Does it Work?

Short selling of stocks refers to the practice of selling stocks that the investor does not own with the intent of repurchasing them at a lower price in the future. Short selling of stocks allows the trader to profit from stock price declines and make money during bear markets.

Traders often talk about making money trading by “Buying Low and Selling High”, typically this is done by first buying and then selling… but when you short sell a stock, you sell high first and then buy it lower later (hopefully). So the mathematics of making a profit is the same as a regular long-side stock trade; it is just the sequence of events that is different, as illustrated in the diagram below:

For short selling of stocks to be possible, a trader first needs a broker willing to lend the stock to them. The trader then sells the borrowed stock on the open market and receives the proceeds from the sale. If the stock price decreases as the trader hopes, they can repurchase the stock at the lower price, return it to the lender, and pocket the difference as profit. If the stock price increases, however, the investor will incur a loss when they repurchase the stock at a higher price and return it to the lender.

When the trader is short selling a stock, they incur the normal commission/brokerage in addition to a stock borrow fee which is a percentage of the value borrowed, charged per day. The trader is also liable to pay any declared dividends in cash to the original owner of the stock they borrowed.

In practice, your broker handles this whole process automatically and seamlessly. Brokers typically have arrangements with large shareholders who receive a portion of the stock borrow fee in exchange for allowing the broker to loan their shares to traders who wish to sell them short.

The Risks and Rewards of Short Selling a Stock

One of the main risks of short selling is that the potential loss is theoretically unlimited. If the stock price rises dramatically, the trader will have to pay the difference out of their account when they repurchase the stock and return it to the lender. For example, If you open a short position by short selling a stock at $10/share, there is a possibility that the stock could go up to $20, $50 or $100 or more, losing you large sums of money.

In contrast, the best you can do when short selling a stock is to have the price go to zero. For example, if you open a short position by short selling a stock at $10/share and the company announces bankruptcy and ceases trading forever, then you have made a 100% profit on the stock. This is the absolute best you can do when short selling a stock!

The loss and gain potential when short selling a stock are illustrated in the diagram below:

Because of the asymmetry of the potential gains and losses, short selling a stock is much riskier than buying a stock on the long side. It is important to have defined exit points and a stop loss to protect you from the unlimited loss potential. When short selling a stock, you must not let losses get out of control because they can mount up to be many times larger than your initial investment.

Another risk of short selling is the possibility of a “short squeeze,” in which the stock price increases rapidly due to a lack of supply, forcing the investor to repurchase the stock at a higher price and resulting in a significant loss. A notable recent example of this occurred with a US stock called Gamestop, which was the subject of a coordinated short squeeze by a large group of retail traders through a Reddit group. Here is what happened:

A trader whom was short GME going into the short squeeze could easily have blown up their account if they were not watching the market and didn’t exit their short trade in time!

Despite the theoretically unlimited risk, short selling of stocks can be a very profitable strategy, especially in a bear market. Fast profits are possible on the short side because when stocks fall, they tend to fall much quicker than they rise. As the saying goes:

The stock market goes up the stairs… and it goes down the elevator shaft

Short selling of stocks in a bull market is risky and challenging, and traders will have much greater chances of success if they limit shorting to bear markets. One of my favourite stock trading systems, called The Slippery Dip, is a system that makes money by short selling of stocks on the US stock market when it is in a bear market. It finds weak stocks and shorts them when the US stock index falls into a bear market. The Slippery Dip is available to all members of The Trader Success System.

Here is a backtested equity curve of The Slippery Dip trading system that was produced using Amibroker with Norgate data, including delisted stocks back to 1990:

Notice that the significant gains for this system that short sells stocks occur during the major bear markets, including the 2000 tech bubble burst, the 2008 Global Financial Crisis, the Covid Crash of 2020 and the 2022 bear market.

The backtested equity curve above is precisely why short selling of stocks is such a powerful trading strategy to add to your portfolio because it makes money when long-side trading systems are losing money or are sitting in cash.

Finding the Best Broker for Short Selling of Stocks

When selecting a broker for short selling of stocks, there are several important considerations:

1. You must qualify for a margin account to start short selling in stocks
2. You want a broker with the broadest range of stocks to sell short
3. You also want your broker to charge the lowest possible stock borrowing fees

I use Interactive Brokers, however, other brokers can also facilitate the short selling of stocks in your account. Of course, it is also essential for you to choose a reputable broker regulated by a major financial authority (Eg. In the US, Australia or Canada… NOT Cyprus 😂🤣).

Famous Examples of Short Selling in Action: Successes and Failures

There have been many famous examples of successful and unsuccessful short selling of stocks. One notable example of a massively successful short sale was during the subprime mortgage crisis in 2007 when Michael Burry (and others) made large profits by short selling of stocks from companies that were heavily invested in subprime mortgages.

A famous example of a large short sale of stocks that went wrong was in 2001 when short seller James Chanos lost billions of dollars by short selling the stock of Enron, which ultimately filed for bankruptcy due to accounting fraud.

Short Selling Frequently Asked Questions

Short selling can be a complex and nuanced trading strategy, and traders frequently have questions about it. Some frequently asked questions about short selling include:

• What is short selling?
• What are the risks of short selling a stock?
• What are the benefits of short selling a stock?
• Can short selling be used for market manipulation?
• Is it possible to short sell a stock that is not publicly traded?
• Can I short sell an index or ETF?
• Is short selling of stocks riskier than trading on the long side?

What is short selling?

Short selling is a trading strategy in which a trader sells a stock they do not own by borrowing it from their broker or another party and selling it on the market to repurchase it at a lower price in the future so they can return it to the owner. The difference between the price the stock was sold at and the price it was purchased back by the trader is the profit/loss realized by the trader.

What are the risks of short selling a stock?

The primary risk of short selling a stock is the price rise. The challenge with short side trading is that the stock price can theoretically increase to any level, so the loss on a short trade is theoretically unlimited. This can lead to significant losses if the trader is not attentive and does not have a stop loss to prevent the losing trade from getting out of control.

What are the benefits of short selling a stock?

Short selling of stocks can make money exceptionally quickly under the right market conditions. For example, short selling was highly profitable during the bear market of 2008 and the Covid crash of 2020. The other benefit of short selling in stocks is that the profits correlate negatively with most long side trading strategies. Thus combining a profitable short selling strategy with a long side trading system dramatically improves your risk-adjusted returns and reduces drawdown.

Can short selling be used for market manipulation?

Yes, short selling can be used for market manipulation if a group of investors coordinate to short sell a stock in large volumes. This can drive the stock price down, which triggers the stops of long-side traders, causing even more selling pressure to drive the stock price down further. This is known as “bear raiding” and is illegal (but it could still happen in theory).

Is it possible to short sell a security that is not publicly traded?

Technically it could be possible to short sell a stock that is not publically traded, but this would be very difficult and risky to accomplish in practice. Moreover, the lack of liquidity in stocks that are not publically traded makes this a dangerous and challenging strategy that is likely not worth the effort.

Can I short sell an index or ETF?

Yes, you can short sell indices or ETFs. Most major ETFs are shortable, have high liquidity, and plenty of stock to borrow for short selling. Indices can be short sold using the ETFs such as the QQQ or SPY or sold short in the futures market. The benefit of short selling a highly liquid ETF is that while there is theoretically still unlimited loss potential, an index is highly unlikely to increase in price so dramatically that it would cause a significant problem for the trader.

Is short selling of stocks riskier than trading on the long side?

Short selling is riskier than trading stocks on the long side because the potential loss is theoretically unlimited, and the maximum profit potential on the short side is only 100%. This is the inverse of trading on the long side, where the worst possible loss is 100%, but the upside is theoretically unlimited. Additionally, short selling requires a margin account, which means the trader is exposed to the potential for margin calls and liquidation if their account collateral drops below the minimum margin requirement. In contrast, buying stocks on the long side (without leverage) carries the risk of loss that only extends to the size of the initial investment.