As trading has become more popular since 2020, traders have become increasingly comfortable buying and selling stocks. Many traders have started branching out to other areas of the industry. Some may look into stock options (a contract to purchase or sell a stock at a specified time and price), while others may start to look into the futures or bond markets. Others may begin to wonder, “Can I profit if a stock declines in value?” The short answer is yes.
In this guide to short selling, we will tell all about how short selling works and things to consider along the way.
Key Takeaways
- Short selling involves selling stocks with the expectation that their price will decline.
- The strategy carries significant risks, including unlimited losses and various fees.
- Before short selling, a solid understanding of market mechanics, fees, and risks is essential.
What is short selling?
Short selling sounds a bit complicated, but it’s really just flipping the usual way of trading. Instead of buying low and selling high, you sell high first (borrowing shares you don’t own yet) and then buy them back later at a lower price (hopefully). If all goes to plan, you pocket the difference as profit.
Why short a stock?
Short selling allows investors to profit when stock prices decline. This can be a useful strategy for hedging portfolios, leveraging bearish views on the market, or taking advantage of overvalued stocks.
Pros and cons of short-selling stocks
Pros of short-selling
- Profit when a stock price goes down
Stocks move in 3 directions—up, down, and sideways (yes, that’s a direction). If you’re a buyer (or long a stock as traders say), your potential profit increases as the stock moves up in price above your cost (the price of the stock when you bought). If you’re long a stock and the stock price decreases, as expected, your potential profit decreases. But what if you could bet that the stock price would drop and earn potential profits when the stock price decreases? Well, that is entirely possible with short-selling. You’re betting the stock price will go down after you take a position. Imagine this as betting the Kansas City Chiefs won’t win their next game.
As for the sideways direction, well let’s just hope that doesn’t happen anytime soon because that direction isn’t for bulls or bears because there is no clear trend. - Keep the checks and balances in order
Short selling can act like a watchdog for the market. Short sellers dig into companies they suspect are sketchy or overvalued, and when they uncover fraud, they often share their findings. This can save other investors from throwing their money into a bad deal. - Helps keep the market running smoothly
Short sellers play a big role in keeping the market balanced and liquid. They make it easier for buyers to find sellers, which helps the market function more smoothly. Plus, this extra activity can stabilize prices, giving long-term investors a better shot at buying shares at fairer prices. You can consider short sellers as a “voice of reason.” - A hedge on long positions/portfolios
For experienced investors, shorting can be a smart way to reduce risk. If the market takes a dive, profits from short positions can help balance out losses in long positions. Investors can even use those profits to buy more of their favorite stocks while they’re on sale.
Cons of short-selling
- Unlimited Losses
Here’s the big risk with short selling: your losses are theoretically unlimited. Why? Because a stock price can keep rising forever—there’s no ceiling.
Let’s compare this to buying a stock the regular way:
If you buy 100 shares of a stock at $100, you’ve invested $10,000.
The worst-case scenario? The stock drops to $0, and you lose your $10,000. That’s it—your losses are capped.
Now let’s flip it:
You short 100 shares at $100, also worth $10,000.
But instead of dropping, the stock price shoots up to $300, $500, or even higher. There’s no limit to how high it can go. Suddenly, you’re on the hook for a lot more than your initial $10,000.
It’s like this: buying a stock is risky, but shorting a stock? It’s risky with a capital R. The higher the price climbs, the more you owe.
And if the loss grows beyond the cash in your brokerage account? That’s when your broker might issue a margin call, requiring you to deposit more money ASAP. If you don’t, they’ll be forced to liquidate your positions to cover the losses. - Margin Call
As I just said, a margin call occurs when your broker calls you and may require additional funds to be made available by wire. Failure to meet the margin call may result in the forced liquidation of positions to cover the losses due to rising stock prices in a short position.
So, what causes margin calls? The most common cause is a lack of risk management and stubbornness by the trader to accept a loss. The other is short squeezes. - Less potential gain
Stocks can only drop to $0, capping profits at +100%, whereas losses are limitless. - The market’s long-term upward bias
Historically, markets tend to rise over time, making short selling inherently riskier. - Halts
Another risk involved in short selling is if the company’s stock halts trading while you are short, you will not be able to close your short position. Halts tie up the capital required for the trade until the stock un-halts. If the stock is halted for a number of days, weeks, months, years, or indefinitely, not only will you be unable to access the capital from the position, but you will also still be responsible for any fees related to the short position even though you cannot close the position.
What is a short squeeze?
A short squeeze happens when the price of a heavily shorted stock skyrockets, leaving short sellers scrambling to cover their positions (buy back the shares they borrowed). This buying frenzy pushes the price even higher, creating a vicious cycle.
Let’s look at a famous example: GameStop (GME) in January 2021.
GameStop’s stock was trading at around $18 per share, and a massive number of shares were shorted—way more than what was actually available to trade (over 100% short interest). Then came Reddit’s WallStreetBets community, where retail traders banded together to drive up the stock price.
Within weeks, GameStop’s price shot up to $483. Short sellers, who had to buy shares to cover their losses, only added fuel to the fire. The result? Billions of dollars in losses for hedge funds and early retail shorts and massive gains for early retail traders who bought the stock.
Imagine this scenario:
- You shorted 100 shares of GME at $20, expecting the stock to drop.
- Suddenly, the stock price jumps to $100. To cover your position, you now need $10,000—five times your original short sale proceeds.
Short squeezes are every short seller’s nightmare, and they’re a big reason why this strategy isn’t for the faint-hearted.
What does a short squeeze look like?
AMC Short Squeeze
GME Short Squeeze
How Shorting a Stock Works
We’ve covered the situations where short-selling might be used as a trading strategy. Now, let’s talk about how it works. Short selling involves borrowing shares from someone who owns them, selling them on the market, and repurchasing them at a lower price.
Historically, the US stock market tends to increase in price over time, so short-selling largely depends on accurately predicting price declines and timing the market effectively.
A step-by-step process for short-selling
The mechanics of short selling are considerably different from the mechanics of purchasing stock. First and foremost, you need to identify a stock you believe will decline in value.
Once you have found a stock that you want to short, you have to receive a valid short locate of the stock before executing any short sale. This can happen in a couple of ways.
First, the stock may be on an easy-to-borrow list. If it isn’t on an easy-to-borrow list, then you will have to ask your broker to locate the shares. When a locate is required, the stock is referred to as hard-to-borrow.
Easy-to-Borrow
If a stock is easy-to-borrow, it means plenty of shares are available to short, and you can borrow them with minimal hassle and low fees. Brokers usually keep an Easy-to-Borrow list that’s updated daily, so if the stock you want to short is on that list, you’re good to go. This list is usually published inside your trading platform, so you don’t have to keep track of it.
Hard-to-Borrow
Some stocks, though, are hard-to-borrow. This happens when shares are in high demand but not widely available. Your broker will need to track down the shares for you (called a locate), and if they succeed, you’ll likely have to pay a hard-to-borrow fee, which depends on supply and demand and is charged on a per-share basis.
The locate process isn’t automatic. Once your broker offers a locate, you’ll need to accept or decline it—and you may need to act fast because other traders are requesting those same shares. A tool like the Locate Monitor in DAS Trader Pro can help streamline this process by showing available shares, fees, and timing for hard-to-borrow locates.
Here’s where it gets pricey: some brokers charge a locate multiple (or overnight fee) if you hold the position overnight. This multiplier can range from 1x to 4x the original locate fee, and it adds up quickly.
Example:
Your broker locates 100 shares of XYZ stock and the locate fee is $0.05/share. The cost of the locate is $5.
- 100 shares x $0.05 per share = $5 locate fee
Now, you decide to hold the position overnight. Your broker charges a 4x overnight fee:
- $5 locate fee x 4 (locate multiple) = $20 per night
If you hold for 5 nights, the cost jumps to:
- $20 x 5 nights = $100 in overnight fees
Pretty steep, right?
Here’s the quick takeaway:
- Easy-to-Borrow = Plenty of shares, lower fees, easy process.
- Hard-to-Borrow = Fewer shares, higher fees, and costs can snowball if you hold overnight.
Summary of Steps for Shorting a Stock
- Identify a stock you believe will decline in value.
- Confirm the stock is available to borrow, either on the Easy-to-Borrow list or as a hard-to-borrow that must be located through your broker.
- Borrow the stock and sell it, either at the current market price or at the price you specify and then wait for the stock to move to your price.
- Monitor the stock’s price movement and your position after your order is executed.
- Buy back the stock (cover) at a lower price (hopefully) and return it to the lender.
Short Selling Costs
There are a few common terms you will hear when researching costs associated with short selling. The most common are borrow fees. Some other fees that you should know about are as follows:
Short Interest Rate
The short interest rate is an annual fee charged daily, determined by supply and demand for shorted shares. Most day traders ignore this cost as it’s quite small when trading intraday. If you plan on swing trading as a short seller, you’re going to need to be a bit more familiar with how this cost works, along with overnight borrow fees.
Dividend Payments
Short sellers must pay dividends if holding a short position on the dividend record date.
How to Time a Short Sale
Effective timing involves understanding market trends, technical analysis, and identifying overvalued stocks or bearish market conditions. Traders must also consider earnings reports, news events, and other catalysts that may impact stock prices.
Short Selling Example
Let’s say you think XYZ Company’s stock price is overvalued at $50 per share. You borrow 100 shares from your broker and sell them for $50 each, which would be $5,000 in sales proceeds. Now you wait, hoping the stock price drops.
A few days later, XYZ’s stock falls to $30 per share. You decide to buy back the 100 shares (called “covering”) for $30 each, resulting in a buyback cost of $3,000. After returning the borrowed shares to your broker, your profit is the difference between what you sold them for and what you bought them back at:
- $5,000 (sale proceeds) – $3,000 (buyback cost) = +$2,000 profit
But let’s say things don’t go your way. XYZ’s stock jumps to $70 per share instead. Now, you’re forced to buy back the 100 shares at $70 each, a $7,000 buyback cost. That means you’ve lost:
- $5,000 (sale proceeds) – $7,000 (buyback cost) = -$2,000 loss
This is why short selling is risky—the price can rise indefinitely, and losses can snowball fast.
Regulation SHO
Regulation SHO, or Reg SHO, is a set of rules created by the SEC to keep short selling fair and prevent shady practices like naked short selling (selling shares you haven’t borrowed or located). Think of it as a rulebook that makes sure traders and brokers play by the same guidelines to keep the market balanced and transparent.
What Regulation SHO Does
- Locate Rule
Before you short a stock, your broker has to find (or “locate”) shares to borrow. This ensures the shares are actually available to deliver when the trade settles. It’s like making sure you have the keys to a car before you promise to lend it to someone. This rule helps stop naked short selling, which can mess with stock prices by adding artificial selling pressure. - Threshold Securities List
Every day, the SEC puts out a list of stocks (the Threshold Securities List) that have a lot of “fails-to-deliver.” A fail-to-deliver happens when someone sells shares but doesn’t actually deliver them by the settlement date. If a stock makes it onto this list, brokers and traders need to pay close attention to avoid further problems. - Close-Out Rule
If a stock stays on the Threshold Securities List for five days in a row because of delivery failures, those short positions need to be closed out ASAP. This means buying the shares to cover the position. It’s the SEC’s way of saying, “Fix this now before it gets worse.” - Marking Short Sales
When you place a short sale, your broker has to label it properly. Orders are marked as either:- Short (you’re borrowing shares to sell), or
- Short Exempt (you’re skipping certain short-sale price rules for specific reasons).
This tracking helps regulators keep tabs on how much short selling is going on in the market.
Why You Should Care About Reg SHO
Regulation SHO keeps short selling in check by making sure shares are actually available and delivery failures are cleaned up quickly. Without it, there’d be more opportunities for market manipulation, and stocks could get hammered unfairly.
For traders, it’s a reminder to work with a broker who plays by the rules. You don’t want to get caught up in any messy situations because someone skipped the locate process or didn’t close out positions on time.
Why Do Short Sellers Have to Borrow Shares?
Short sellers have to borrow shares to make sure everything’s legit and follows the rules. If they didn’t, it would be naked short selling—which we’ve already covered as a big no-no in short-selling because it is illegal and it can mess with the market.
But here’s where it gets a little weird: why would anyone loan out their shares if they want the stock price to go up? Doesn’t that kind of work against their own interests?
Well, there are two main reasons:
- Money Talks: Investors get paid a fee when their shares are borrowed, so it’s a way to earn a little extra cash.
- They Don’t Always Have a Choice: Most people don’t realize that when they buy shares, their brokerage account agreement often allows the broker to loan out those shares without asking.
So, do shareholders still own the shares? Technically, yes—they still “own” them. But the broker or custodian has the right to lend those shares out, and most of the time, it’s buried somewhere in the fine print of the account agreement.
At the end of the day, borrowing shares keeps short selling above board and makes sure traders are following the rules. It might seem counterintuitive, but it’s just how the system works.
Is Short-Selling Ethical?
Short selling gets people pretty fired up. Some think it’s a solid way to keep things in check, while others see it as rooting for failure. It’s like betting on your favorite team to lose—it just doesn’t sit right with everyone.
Why People Aren’t Fans of Short-Selling
Let’s be real: short selling can look a bit shady. It puts pressure on a company’s stock price, which can make it harder for them to grow, raise money, or even keep their reputation afloat. Imagine you’re running a business, and instead of cheering you on, people are betting against you. Ouch, right?
There’s also the risk of dirty tricks. Some folks spread bad or flat-out untrue rumors in an attempt just to tank a company’s stock and cash in on their shorts. That’s not just bad for the company—it can hurt the people working there and the communities around them.
Why Others Think Short-Selling Is a Good Thing
On the flip side, short selling can actually be pretty helpful. It’s like having a built-in lie detector for the market. If a stock is overhyped or the company’s hiding something shady, short sellers are usually the first to call it out.
Plus, it keeps things moving. More trades mean more opportunities for everyone, and short sellers help set more realistic prices for stocks. So, instead of a stock being priced like a diamond when it’s really a cubic zirconia, short sellers help bring it back down to earth.
Short selling isn’t all bad or all good—it’s how people use it that makes the difference. If you play by the rules and do your homework, short selling can be a legit way to keep the market balanced. But if you’re out there spreading fake news or pulling shady moves, you’re just adding chaos.
At the end of the day, it’s like most things in life: handle with care, and don’t be a jerk about it.
Is short selling a good strategy?
Short selling is a powerful strategy, but it’s not for the faint of heart. If you’re thinking of trying it, make sure you understand the risks, costs, and mechanics. With the right broker like Cobra Trading, tools, and preparation, short selling can be a valuable part of your trading strategy—but always remember to trade responsibly!
