Buying shares isn't the only way to make money in the stock market. Sometimes, going short is the best trade you can do. Read on to learn more about master investor George Soros' favorite moneymaking tool, the short sale, and soon you'll be ready to short a stock in your own portfolio.
Risky business
Short-selling is the easiest way to make a negative bet on a stock. It's the logical opposite of buying low and selling high, in the traditional order. Instead, you're borrowing shares to sell them at a high price, hoping to buy at a lower price later on and then returning the borrowed stock. Sell high and buy low, not the other way around.
Yes, this means selling shares you don't actually own.
Bears want to make money, too. Image source: Getty Images.
Because you're borrowing shares to make this negative bet, the process includes a few wrinkles that don't appear in the normal process of buying shares directly.
- Your accounts needs to be approved for margin trading, and any short-sale balances will count against whatever borrowing limits your stock broker has set up for your account. Since margin trading doesn't go together with retirement accounts, short-selling is not going to be available in your IRA account. It's a strategy strictly reserved for your taxable trading accounts.
- The margin trade adds its own set of risks. First, you broker will charge you interest on the borrowed funds, cutting into whatever returns your short-selling trades might produce. But that's just the beginning. The Financial Industry Regulatory Authority sets regulatory limits on how much equity your account must hold to support your margin balances. Brokers often raise these limits on their own to cut their lending risks. If your equity at any time falls below those limits, you'll be forced to come up with more funds or reduce your borrowed funds balances. This could happen in a hurry if your shorted stocks suddenly skyrocket. The resulting short-squeeze on a stock with very large short-selling interests can be powerful enough to drive share prices even higher as many of your fellow investors get caught in the same trap.
- Someone, somewhere actually does own your shorted shares. The lender -- typically your online stock broker -- could close out your borrowing contract at any time, forcing you to buy back the shares you sold earlier and return that stock position to the original holder. If your shorted stock is trading higher than your original short-sale price at the time, you'll have to eat that loss.
- Shorting a generous dividend payer will force you to cough up those dividends out of your own pocket to reimburse the share lender. Don't forget that you already sold those shares to someone else, who is collecting the actual dividends from the company. So this will be fresh cash from your wallet to the share lender's, and nobody has to reimburse short sellers for these expenses.
Between the risks of forced buybacks and short squeezes, the obligation to cover dividend payments, the limited upside and unlimited downside to short-selling bets, and the many downsides to trading stocks in margin accounts, I totally understand if you don't want to sell anything short now.
OK, but my short-sale idea is worth it!
All that being said, it's very easy to sell stocks short if you have a brokerage account ready to go with margin trading enabled.
It's as easy as placing a regular "buy" order, actually. You just change that "buy" instruction to "sell short," make sure you're placing an order with a firm limit price, and off you go:
Short-trading example, using TD Ameritrade's order system to illustrate the process. No, the trigger was never actually pulled on this hypothetical order. Image source: author.
As soon as that order is filled, you'll be the proud owner of a short position. Keep an eye out for the risks mentioned and be ready to close that position -- "buy to cover" the same shares you just instructed the system to "sell short" -- when your pessimistic investment thesis has played out.
Short-selling is not the only negative bet available to investors. You could also use options strategies such as selling calls or buying puts, but those tools are more useful in combination with straight-up stock positions and other option stakes to build a sophisticated framework of balanced risks and rewards. There are also mutual funds and exchange-traded funds set up to make negative bets on the market as a whole or against certain sectors.
Or you could just bet a keg of beer with your amigos that a certain stock is destined to crash. Your choice, really.
