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What is short selling on the stock market?

This may be one of those stock market jargon terms that makes you glaze over when you hear it. On the other hand, perhaps now might really be the time to find out, what is short selling on the stock market?

Short selling on the stock market is when you, borrow stock from a broker that you sell now at the current market price because you believe or think that the price is going down. You hope you will be able to buy the stock at a lower market price in the future so you can return the borrowed stock to the broker.

Bear market decline

When you borrow stock from a broker, the broker will charge you commission fees and interest. The whole point of short selling is that you expect the gain more money on the difference between the high price you sold the stock at, and the lower price that you paid for the stock at a later time, after you deduct the commission and interest fees your broker charges you in between you selling the stock, short, and you buying back the stock to close your position.

It is much easier to see how this works with a diagram or two.

Short selling – how it works

Short selling opening position

In simple terms there are three players, i) you, ii) a broker, and iii) the market.

1. The first step is that you spot an opportunity. You see that XYZ Co shares are currently trading at $100 a share and for whatever reason, you are convinced that the price is likely to drop. You decide you are going to sell the shares short. You do your calculations of the probable price levels and how much you are willing to risk and you estimate that you should sell 100 shares of XYZ Co short.

2. You approach a broker, usually your own broker with whom you already have an account that is approved for borrowing on margin. You borrow 100 shares of XYZ Co.

3. You sell the 100 shares in XYZ Co at the market price of $100 per share. At this point, a readout of your account with the broker will show a line with XYZ Co, a quantity of minus 100 and in the value or balance column, a minus figure of $10,000 with any commissions and fees added. In fact, with an online broker steps two and three are achieved with a few mouse clicks.

One month passes. As you anticipated the share price of XYZ Co has now dropped to $80 a share and you expect that it is unlikely to go any lower. Or even if it does go lower you think your prediction has run its course. You decide to close your position and settle your account.

Short selling closing position

4. You buy 100 shares of XYZ Co at $80 per share.

5. You return the 100 shares of XYZ Co to your broker.

6. Your account is settled. Again with an online broker steps four, five, and six are achieved with a few mouse clicks.

Depending on the margin arrangements for your account, all commissions and interest fees would typically be deducted at this point. The broker will likely charge a commission to open the position when you borrow the shares, commission to close the position when you returned the shares and interest for the duration that you held the position open.

Trading on margin

When you short sell stock you are borrowing the stock from your broker. As that is a loan like any other, your broker will charge you interest. The rates of interest your broker will charge are typically on a scale starting with a higher rate if your account balance is the minimum needed for margin trading to progressively lower rates as your account balance increases.

Margin interest rates are usually about the same or a few points lower than the rate a retail bank will charge you for a line of credit.

Why sell short

When we think of investing in the stock market we tend to automatically think of buying shares at one price in the hope that the price will appreciate and we would sell them at a later date for a profit. That approach predisposes investors to gain from rising prices only.

Short selling stock allows you as an investor to profit from declining stock prices. There are risks involved in short selling that are not present if you are just buying and holding stock expecting to profit from a price increase.

If the price of a stock that you have sold short rises instead of falls, then your broker will usually ask you to deposit or transfer more money as collateral against your short position. Such payments or transfers are called margin calls.

The risk with short selling is that you can end up losing more than you put up as margin. With buying and holding stock you can only lose the amount you paid for the stock.

If the stock price moves against you, you can either make the margin call and close out the position at a loss, or you make the margin call and maintain the position if you still think the price will drop.

There are other ways to profit from declining stock prices, either from buying put options or selling uncovered call options.

Selling short alternative – buying puts

Another potentially less risky way to profit from a declining stock price is to buy put options in that stock.

As the buyer of a put option, you have the right but not the obligation to sell the stock at a set price called the strike price at or before a future date. This is easiest to explain with the same example of XYZ Co stock.

Let’s imagine, again that you see XYZ Co stock is being traded on the market at $100 today and you expect that the price will drop to $80 in about two months from now. You could buy a put option with a strike price of $90 and an expiration date that is three months, or 90 days out leaving you a bit of a time buffer for the price drop to happen.

Each option actually controls 100 shares. Let’s imagine that a put option with a strike price of $90 that is 90 days out could be bought for $5 per share controlled, so would actually cost $500.

Because the strike price of the put option is lower than the market price, it is referred to as out of the money. But because there are still three months to go and the price can change in that time, you actually pay a premium for the option that is reflected in the price.

Options pricing is actually quite complex though it does follow some simple basic principles. The time to expiry, how far the strike price is from the current market price, and the volatility of the stock are all reflected in the option price. Options are also traded during their lifetimes i.e. before they expire and the prices of options changes over time. Effectively the time value reflected in the option decays as the expiry date approaches.

Let’s consider our $90 strike put that still has 90 days to run for which we paid $500. Here’s what that would look like.

Buying a put option

If the price does not change at all over the 90 days, then the option price will gradually decrease over time, and when it expires the option will be worthless. There is no value to being able to sell 100 shares of XYZ Co at $90 a share when the market is selling them at $100 a share.

Let’s imagine that like with the short-selling example, one-month passes and the share price of XYZ Co drops to $80 a share, . We could choose to exercise our option to sell at $90 while buying back at $80, so a $10 per share gain or $1,000 for all 100 shares. So we would make $1,000 less the $500 upfront cost of the option less any commission fees.

However, the better thing to do, if we didn’t want to watch what happens for the next 60 days until expiry would be to sell the option in the market. With 60 days to go there would be some time value reflected in the option price. Keeping that math simple, that time value could be as much as $5 per share in the option, so the option would be worth $1,500 at the market.

This is what that would look like.

As we can see in this example short selling actually yielded a higher profit. That isn’t entirely surprising, firstly because the numbers are fictitious, but we should also consider the different risk exposures involved in each approach.

If the price of XYZ Co shares increased rather than declined after you had opened the short position, then you would have received repeated requests from your broker to increase the margin. Let’ say the stock price went up to $150 and you closed the position. That would have cost you $5,000 plus commission and interest.

On the other hand, the risk exposure of the put option is limited to the cost of the put in the first place which was $500.

Real puts – for comparison

As I said the example above used fictitious round numbers. Here is a look at how close a real example would come,

Best Buy Inc. symbol BBY, is currently trading at nearly $100 a share. The $90 put option that expires in 77 days – that is the closest currently to 90 days – costs $3.92. So one put would cost $392.00.

To avoid waiting for a month, hoping almost certainly in vain that Best Buy share price would oblige and drop to $80 for the benefit of our example, we can compare with a BBY put option that is $10 in the money, i.e. with a strike price of $110.00 and expires in 49 days, i.e. a month sooner than the $90 put – which is $10 out of the money. The $110 put option is currently priced at $14.76.

So using this example, we would pay $392.00 and a month later sell the option for $1,476.00, less say $1 in commissions so a profit of $1,083.00. So the real-life example did a little better.

Selling uncovered call options

There is another approach to profiting from declining stock prices. If you have no experience trading options or other financial derivatives this might be a bit of a challenge to get your head around, but here goes.

Rather than selling the stock of XYZ Co short, you can choose to sell call options. This is just taking the opposite side of a call option trade which means you have given them the right to buy the stock. That means you have assumed the obligation to sell the stock. Effectively that means you take on all the risk that the buyer of the call has paid you to take on. If you don’t own the underlying XYZ Co stock, this is referred to as selling uncovered call options. It is like owning a put option but you take on all the downside risk that the purchaser of a put option is avoiding. Really selling a call option is taking on a put obligation.

This sounds like a very risky proposition. If the market moves against you yes this will cost you money. It has one advantage though when you sell either call or put options whether covered or uncovered, you receive the price of the option into your brokerage account. If you know what you are doing and manage your risk well, selling both uncovered and covered call options can be a good way to make income and build your portfolio.

Some questions and answers

Q. What is short selling on the stock market?

A. To short sell, you borrow stock from your broker, then you sell that stock at the current market price. When the market price drops you buy the stock at a lower market price and you return the borrowed stock to the broker.


Q. How do you borrow a stock to short sell?

A. You need an account at a broker that is approved for margin trading. If this is an online broker, once your account is approved you will be able to borrow and short sell with a few mouse clicks.


Q. Is Short selling considered day trading?

A. Day trading is just trading within a single day time horizon. It involves buying and selling long and short positions and closing those positions within the same day. Short selling can be a part of day trading if you choose to use short selling and if your broker gives you that facility.


Q. Who loses in short selling?

A. Short selling is just a part of the supply and demand conditions that determine stock prices. Short selling is only possible if holders of stocks are willing to loan the stock to a short seller. Short sellers add to the volume of orders in the market which contributes to liquidity. If prices drop short-sellers win and stockholders who sell out at a loss lose. If prices rise, stockholders or traders with long positions win and short-sellers lose.


Q. Do you pay interest on short stock?

A. Yes. A broker will charge you interest on stocks that you short sell. The rate of interest will vary depending on the balance in your account. The interest rate charged should be less than you would be charged on a credit card or on a standard checking line of credit.


Q. Why is short selling bad?

A. Short selling is not necessarily bad if you do it responsibly, carefully, and following a well-defined strategy. On the other hand, if you take a wild and reckless approach to short selling you are likely to lose money.


To read about one of the most famous short-sellers of the early 20th century, Jesse Livermore click here.

To learn more about the details and history of short-selling, check here.

Here is a single-page summary that explains short selling. You can download a PDF here.

Short selling summary


I hope you found this article interesting and useful. Do leave me a comment, a question, an opinion or a suggestion and I will reply soonest. And if you are inclined to do me a favor, scroll down a bit and click on one of the social media buttons and share it with your friends. They may just thank you for it.


Disclaimer: I am not a financial professional. All the information on this website and in this article is for information purposes only and should not be taken as investment advice, good or bad.

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30 Comments

  1. Thank you for sharing this very, informative article with us. The chief item of this article is What is short selling on the stock market? It is truly amazing that you covered this subject so well in your post. I’ve learned a lot from reading your post and gained a lot of knowledge about it. I now understand Short selling – how it works from the points in your article.
    Although I have only basic ideas about trading, I really enjoyed reading your article and those who are real traders will benefit from it so I would like to share your article on my Facebook group if you allow me.

    • Hi and thanks for your comment. Please do share the article with your friends on Facebook. Best regards, Andy

  2. Hi Andy,

    Thank you for this detailed explanation of what short selling is. I might say, after reading your detailed explanation , it seems there is more risk involved here than in just buying the stock.

    Yes, it can bring more money to you if the prediction you make it is right, but you need both luck and research about the stock to make such a prediction.

    I am serious thinking investing in stocks but short selling seems to be an option I would not make unless I am sure the stock is going down.
    I believe this move is for more experienced investors that are aware of the market ups and down and can better predict.

    Thank you very much
    Kind regards,
    Yoana

    • Hi Yoana
      You are absolutely right. Short-selling is really for experienced traders. It isn’t something people start out doing. Nor would that be a good idea. Most investors and traders trust themselves to try buying put options first before venturing into short-selling. It is also one of those things many of us hear about but often don’t fully understand. Thanks for your comment and best regards, Andy

  3. Very informative article. You explained it in simple format and simple language. Thank you. How about setting stop losses when you are short selling. How does that work?

    • Hi and thanks for the comment. Yes, it is always advisable to set stop-loss orders especially when you have theoretically unlimited risk as is the case with short-selling. Different traders have different approaches to setting stop-loss orders. The simplest approach that many adopt is just to set a stop-loss at a set percentage below the opening position. That only really works well if you always use the same position size and always trade one kind of security for example stocks. But if you have a mixture of stocks and options in your portfolio it is better to calculate the maximum loss you would be willing to tolerate on each position and from there calculate what a stop-loss level should be. This is a big subject worthy of its own examination. Thanks again for the interesting comment. Best regards, Andy

  4. Hi Andy,

    I would like to thank you for this informative article. To be honest to me this a new subject. So in a way there is too much info at once.

    Keep up with this

    Anestis

    • Hi Anestis
      Thanks for the comment. Yes, the subject can be a bit much to absorb sometimes. Nevertheless, I hope you were able to find one or two useful pieces of information.
      Best regards
      Andy

  5. Well put together post man. I am a professional Forex trader myself and I have not really looked at stocks but it seems to be interesting.
    This article has given me a lot of insights about this field.
    It seems stocks can give you a huge leverage however I have also heard that it requires high capital to start. Is this true?

    Does selling stocks differ to Forex or it is the same?

    • Hi Thabo
      That’s funny that as an experienced Forex trader you are wary of stocks. The technical analysis approach to charting stock price movements is pretty much the same as for Forex. You will find exactly the same kinds of candlestick patterns, head and shoulders, doubleheaders, wedges, etc and in particular Fibonacci levels apply equally well to stock prices as to currency prices. I guess if there is one major difference it is how earnings news, corporate news, and political news can impact individual companies and industry sectors. As regards leverage, yes it is possible to use options in particular and margin trading to achieve substantial leverage to increase both upside potential and downside risk. I think any major brokerage account will give you the facility to trade stocks and options as well as Forex. Thanks for the comment and the question. Best regards, Andy

  6. Hi Andy,

    This is a very informative and insightful article. I have never heard of short selling before, but it’s great that you have discussed it and enlightened us with your very thorough knowledge. I truly believe that a lot of people within the trading world will benefit from this article. So, hopefully you will receive a lot fo traffic.

    Thank you for sharing and keep up the great work.

    All the best,

    Tom

  7. Thanks for this information post. I definitely learned a lot. I am not quite into stocks yet, but investing is something that I want to start doing once I have a bit more money. I just graduated high school. When do you think is a good time to start or should I do something else first?

  8. A good read Andy. I’m not overly close to the markets these days but I’d be interested to see how the short-selling players are doing. A whole bunch of geo-political and other variables out there at the moment so only for the brave. I’m more of a long player but I’ve got a bunch of years on my side so fingers crossed long term predictability ultimately prevails.

    All the best – Jason.

    • Hi Jason and thanks for the positive feedback. I am also more of a long-player, though I’m guessing I have fewer years to go than you do so I’m crossing my fingers and my toes. Good luck to both of us! Best regards, Andy

  9. Hi Andy,

    This is a very informative and useful article. Thank you for sharing.
    I’m a long-term player and I never try short selling before because I don’t know its specific practice. Now, thank you for your explanation and clear pictures shown in the article. I get the basic concept about short selling now. I may try to put a small amount of money to give it a shot.

    All the best,

    Alex

    • Hi Alex
      Like you, I don’t short sell. I do buy puts now and then and I recently sold a put for an ETF that I would not mind owning if the market price did decline to the strike price of the put. I ended up closing that position still with some gain but it was one of those situations where I was watching the market all the time hoping the price wouldn’t drop. So I decided it was better for my stress level and sleep to close the position with the gain that I already had achieved. Thanks for the comment. Best regards, Andy

  10. Hello Andy, I have really enjoyed every minute I have spent on your site reading about trading and it’s been really amazing because there are a few things I needed to know which I have just found out here. Trading online and making profits from it is all we all want but some people are bad at reading a trade and they end up losing money and that’s bad. Thanks for sharing 

    • Hi Justin, thanks for your positive comment. I am very glad you found the article informative. Best regards, Andy

  11. Hello Andy, as a lady, I have been really away from anything that had to do with trading because I felt it wasn’t for me and how bad that decision is. Lately I have been really following the stock market and seeing how some people take it seriously. I wish I had taken more interest in it. Searching the Internet and getting this article has given me so much to ponder. I look forward to seeing more of such nice articles from you. 

    • Hi and thanks for the kind and positive comment. Please do check out other articles and don’t hesitate to leave other comments, questions, or suggestions. I will respond soonest. Best regards, Andy

  12. Good information. Thanks for sharing.
    I was looking for new ways to invest and make money, so learned a lot from your article. However, the main thing I learned was that short selling requires a high level of understanding of the markets. I am not there yet, as I am a beginner, so I will not be investing in short selling any time in the near future.
    I wish you all the best!

    • Hi and thanks for your comment. I agree 100 percent with your decision. If you are just starting out I would absolutely steer clear of short selling stocks as the downside risks really are unlimited. Thanks again and good luck. Best regards, Andy

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