Here's What All Investors Should Know About Shorting Stocks

Shorting is an investing concept that isn't well understood by many people, especially those who are new to the stock market. But we've got you covered. In this Nov. 17 Fool Live video, Fool.com contributors Matt Frankel, CFP, and Jason Hall break down what shorting is, how it works, and what investors need to know about the risks before considering it. 

Matt Frankel: We're going to start with short selling. I'll give you a quick rundown of what short selling means, and then we'll talk about why it's used and how to do it. I'll punt to Jason for that part. Short selling essentially means that it's a way to bet against the stock. Short selling means that you are literally borrowing shares of stock from your broker and selling them to other investors hoping that they go down, and then you could buy them back at a cheaper price and return them to your broker. If I want to bet against, say, Apple at $120 a share, I could borrow 10 shares of it from my broker, sell it to an investor at $120 a share so I get $1,200. My hope is that Apple goes down. If Apple goes down to $100 and I could buy back those 10 shares at $100 a share and return them to my broker, I've taken in $1,200 from completing the short sale, I can buy those shares back for $1,000, and that $200 difference is my profit. Sounds great, right? Jason, why do people sell stock short?

Jason Hall: There's a couple of reasons. Number 1, I want to say that I think short selling is an important part of a healthy market. I think it's a reasonable way to invest. I know a lot of us, we see things on the boards, some Foolish stocks a lot of times get targeted by short sellers and then we get mad about it, and we immediately go to yelling and talking about these bad people and this bad thing they're doing. But I think in general, it's a healthy part of the market. The reason why people do it, and it's something that different Foolish portfolio services have offered, is because it's a way to extract income and profit. The bottom line is that if you see a company that you feel strongly in some reason, or your analysis has led you to believe that the price that investors are willing to pay today is not what investors are going to be willing to pay at some point in the near future, or you truly see some fundamental flaw with the business that's going to erode value and create opportunity, then you may decide to short that stock. Again, like I said, I think it can be a reasonable way to make money. But there's more to it because you also, in addition to the risks which we'll talk about, there's borrowing costs. When you're borrowing shares from somebody, they want something in return. Your broker wants a little piece of the action. So there's costs and interest and that sort of thing because you start taking on margin to short.

Matt Frankel: We'll find out Jason's thoughts on margin in just a few minutes. I'll give you a hint; that's going to be the fun part of the show. Spoiler alert. But like you said, there's a few reasons people sell short, just might think the stocks too expensive? Let's just say that I think Tesla was too expensive.

Jason Hall: I thought that when I was a Tesla shareholder.

Matt Frankel: Let's just say that we think Tesla's too expensive. We would borrow shares, sell them short, and hope to buy them back cheaper. Another reason people sell short is to hedge against their other positions. A lot of people I know buy a short position in the overall S&P 500, for example. They have a portfolio of growth stocks and things like that, but then if the market goes the opposite way and just crashes like it did in March, then that serves as like a backstop and they can limit their losses in that sense.

Jason Hall: You can almost treat it like insurance. Buying "puts" is another option. It's another thing that can be treated like a kind of insurance.

Matt Frankel: Yeah, put options, it's a shorting alternative, I guess I'd call it. It has its benefits, but the mechanics of option trading are for another show for another day.

Jason Hall: That's not a 10-minute segment.

Matt Frankel: No, it's not. That's a good way to hedge. I've bought S&P puts to edge against market corrections and stuff like that in the past.

Jason Hall: You can short an S&P instrument is your point, the same way they create some sort of a hedge.

Matt Frankel: Sure, to create a hedge. That's another key point, that shorting doesn't have to be an individual company. You could just short the market, in other words. But shorting, there is a cautionary aspect of it that newer investors need to know before they do it. I like using Tesla as the example because I call it an unshortable stock, especially for newer investors, no matter how expensive you think it is. I mean, Tesla's what, 450 a share right now? Let's say that you think its intrinsic value is 20 bucks. I don't care. Don't short Tesla. The reason you don't short a stock that's volatile like that is because your losses are unlimited when you short. I mentioned my Apple example earlier where I'd say I'd borrow shares, sell them at 120, hope they go down. If Apple goes up to 200, I now have to buy the shares back at $200 a share and I've lost a lot of money. With some of these high-flying tech stocks, there is no real upper limit to how high they can get.

Jason Hall: I think story stocks in general creates this additional layer of risk. Really, the best way to describe it is it's so much harder to predict what's going to happen. Sure, one could say, well, everything is a guessing game in the short term, and to a certain extent it is, right?

Matt Frankel: Right. I was the guy who called Amazon expensive at $300 a share. People bring that up all the time so I might as well call myself out on it. But let's say I had shorted Amazon at $300 a share. It's now worth $3,000 a share, or even a little bit more.

Jason Hall: 3,148 and change.

Matt Frankel: Right. So your losses are essentially unlimited when it comes to shorting. 

Jason Hall: Here's the best way I figured out to describe what shorting really is. It is entirely the inverse of going long in every way, including the risks and the returns, which are inverted, plus fees that you have to pay to actually do the action. So the most you can make is a stock going to zero where you make all of your money less the fees that you had to pay to short. The most you can lose is tied to your ability to continue to watch the stock price go higher before either your broker forces you to close that short position or you realize that you just need to walk away and soak up a large loss.