Over the course of its history, the stock market has climbed steadily, and most successful investors have sought to buy and own shares of stocks that have gone up over the long run. Owning stocks can be risky: You can lose your entire investment if you choose poorly. But under the right circumstances, shares can rise in value substantially over a period of years. That makes the risk-reward trade-off of traditional stock investing favorable and attractive to many investors.

However, sometimes investors become convinced that a stock is more likely to fall in value than to rise. If that's the case, investing by buying shares will only result in losing money. Instead, if you want to make money when the value of a stock goes down, you have to use a strategy called short selling. Also known as shorting a stock, short selling is designed to give you a profit if the share price of the stock you choose to short goes down -- but to lose money for you if the stock price goes up.

Downward-pointing stock chart next to face of Alexander Hamilton from $10 bill.

Image source: Getty Images.

What is shorting a stock, and why would you do it?

Shorting a stock involves borrowing shares from someone who owns the stock you want to sell short. Once you borrow the shares, you then sell them on the open market, getting cash from whoever buys the shares from you. At some point in the future, you'll buy back the stock and then return the shares to the investor from whom you borrowed them.

Typically, the reason for shorting a stock is that you hope that by the time you buy back the shares that you've sold, the price of the stock will have dropped. That'll let you buy back the shares with less money than you originally received when you sold them. After you return the bought-back shares to the investor who lent them to you, you'll still have some cash left over. That leftover cash is your profit from the short sale -- assuming that the price fell in the interim, as you expected.

However, there are some other situations in which shorting a stock can be useful. If you own a stock in a particular industry but want to hedge against an industrywide risk, then shorting a competing stock in the same industry could help protect against losses. Shorting a stock you own can also be better from a tax perspective then selling your own holdings, especially if you anticipate a short-term downward move for the share price that will likely reverse itself.

How do you short a stock?

In order to use a short selling strategy, you have to go through a step-by-step process:

  1. Start by identifying the stock that you want to sell short.
  2. Make sure that you have a margin account with your broker and that you have the necessary permissions to open a short position in a stock.
  3. Work with your broker to see whether you're able to borrow the shares that you'll need in order to use the short selling strategy.
  4. Borrow the shares, then sell them on the open market.
  5. After a period of time goes by, the share price of the stock you sold short will have gone up, gone down, or stayed the same.
  6. At some point, you'll need to close out your short position by buying back the stock that you initially sold and then return the borrowed shares to whoever lent them to you, via your brokerage company.
  7. If the price of the stock went down, then you'll pay less to replace the shares than you got when you sold them, and you're allowed to keep the difference as your profit. If the price of the stock went up, then it'll cost you more to buy back the shares than you got when you initially sold them, and you'll have to find that extra money from somewhere else, suffering a loss on your short position.

All that might sound complicated, but it's actually a lot easier than it sounds. Typically, you don't have to do much work yourself to identify a prospective lender of the shares you want to sell short. Your broker will act as a clearinghouse to identify other customers who own a stock and are willing to let you borrow it for short-sale purposes.

A simple example of a short selling transaction

Here's how short selling can work in practice: Say that you've identified a stock that currently trades at $100 per share. You think that stock is overvalued, and you believe that its stock price is likely to fall in the near future. Accordingly, you decide that you want to sell 100 shares of the stock short. You communicate with your broker, and you're able to find shares to borrow that you can then use to open your short position.

When you sell the stock short, you'll receive $10,000 in cash proceeds, less whatever your broker charges you as a commission. That money will be credited to your account in the same manner as any other stock sale, but you'll also have a debt obligation to repay the borrowed shares at some time in the future.

Now, fast-forward to sometime in the future, when the stock price has moved:

  • Let's say that the stock has fallen to $90 per share. In that case, you can close the short position by buying 100 shares at $90 per share, which will cost you $9,000. Subtract that $9,000 from the original $10,000 that you received when you opened the short position, and you have $1,000 left. That represents your profit -- again, minus any transaction costs that your broker charged you in conjunction with the sale and purchase of the shares.
  • On the other hand, say the stock price rises to $110 per share. In that case, when you buy back the 100 shares, it'll cost you $11,000. You only got $10,000 from the initial short sale, so you'll have to find the extra $1,000 from somewhere else in order to cover your losses. In addition, you're also on the hook for any commission costs, which can exacerbate your net losses from the short sale.

What are the pros and cons of shorting a stock?

Short selling has pros and cons compared to regular investing in stocks. The biggest advantage of short selling is that it lets you profit from a decline in the value of an investment. Without adding the short selling strategy to your investing toolbox, you have only limited ways to profit from an investment that you think is going to lose value in the long run, and you'll generally have to stick with investments that you believe will rise in value. That works fine during bull markets when there are a lot of stocks going up, but when the market environment turns negative, it can be a lot more difficult to find good candidates for long-term gains.

Beyond the ability to profit from falling stocks, shorting stocks also has some other advantages:

  • You can put together a market-neutral portfolio that includes both owning stocks and selling stocks short. By focusing on buying the stocks with the best prospects and shorting the stocks with the worst ones, you can make money if you're correct, regardless of whether the overall market rises, falls, or stays flat.
  • You can custom-engineer your investment exposure. For instance, say that you want to invest primarily in an exchange-traded fund that owns 10 different stocks, but you're convinced that one of those stocks is a bad bet. By shorting that stock, you can use the ETF to get exposure to the other nine stocks, while the short position will offset any losses in the ETF from owning that 10th stock.

However, there are downsides to short selling. The most important is that there's no theoretical limit to the amount of money that you can lose in a short position.

Consider: When you own shares of stock, the worst thing that can happen is that those shares become worthless, and you lose the entire amount that you invested. However, with a short position, a stock can increase in value by many multiples of its original share price. In that case, you're on the hook for losses that can dramatically exceed the amount of money you received up front. As an example, if you short 100 shares of stock at $10 per share and it jumps to $100, then you'll be on the hook for $10,000 when you buy the stock back -- even though you only got $1,000 in proceeds when you initially sold it short. That huge loss shows just how much is at stake when you decide to short a stock.

Some other cons of short selling include the following:

  • The special regulations that govern short selling are more onerous than what regular stock investors deal with. For instance, in some situations, exchanges will limit short selling activity during times of market volatility, without putting any similar restrictions on those holding regular long positions in the same stock.
  • You don't always have control over when you'll have to close out your short position. If the person from whom you borrowed the shares wants them back, then you won't have a choice -- you'll have to buy back the stock even if you don't really want to yet.

In addition, as you'll see in more detail below, there are some risks to shorting stocks that many investors aren't necessarily prepared to handle.

What types of investors are best suited for shorting?

Because of the potentially unlimited losses associated with short selling, an investor has to have a higher tolerance for risk in order to be successful at shorting stocks. Even professional hedge fund investors often have trouble with the big swings involved in short selling, because even in situations in which it seems clear that a business faces insurmountable challenges, there's no guarantee that the stock price won't continue to rise indefinitely. If that happens, then you have to be able to weather the short-term losses involved while maintaining your conviction that your short position is a prudent one.

In fact, in order to do short selling at all, you have to have what's known as a margin account with your broker. The margin account ensures that if your short position goes against you, your broker will be able to cover any resulting losses in your brokerage account by using a margin loan. If you're not able to qualify for a margin account -- or if you're not willing to assume the obligations involved in having a margin account -- then shorting stocks isn't for you.

What are the risks of shorting a stock?

The biggest risk involved with short selling is that if the stock price rises dramatically, you might have difficulty covering the losses involved. Brokerage companies won't force you to have an unlimited supply of cash to offset potential losses from your short selling activity, but they will require that you keep set amounts of cash or margin loan capacity available, and those amounts will vary as the stock price moves. If you lose too much money, then your broker can invoke a margin call -- forcing you to close your short position by buying back the shares at what could prove to be the worst possible time.

Often, share-price increases occur with short selling activity in mind. In what's called a short squeeze, shareholders of a given stock refuse to sell shares to investors who have sold the stock short, causing the share price to increase dramatically. The rising share price causes more short sellers to need to close their positions, and the result can be a feeding frenzy in which the stock price explodes higher over a short period of time. At some point, shareholders are willing to sell their stock, and the short squeeze ends. But because short sellers have only a limited tolerance for risk, the relief often comes too late -- after the short sellers have already closed out their short positions.

In addition, short sellers sometimes have to deal with another situation that forces them to close their positions unexpectedly. If a stock is a popular target of short sellers, it can be hard to locate shares to borrow. If the shareholder who lends the stock to the short seller wants those shares back, then you'll have to cover the short -- your broker will force you to repurchase the shares before you want to.

What costs are involved with short selling?

Even when things go well with shorting a stock, there are still costs involved. They include the following:

  • Brokers will charge you the normal commissions in order to sell the stock short, as well as to repurchase the shares in order to close the short position. Fortunately, most brokers don't charge different commissions for short sales compared to regular purchases of stock, but it's worth checking with your own broker to make sure that's the case for your account.
  • Some brokers charge a special one-time fee for the extra work involved in obtaining the shares that you'll need in order to short a stock.
  • One major cost of short selling that many investors fail to take into account is the ongoing cost of borrowing shares from a stockholder. Lending fees can vary greatly from stock to stock, depending on the number of shares outstanding and how high the demand is among short sellers to borrow the shares. These fees are generally expressed as an interest rate, and so the longer you keep your short position open, the more you'll have to pay in fees. Widely held stocks that don't have a particularly high amount of short interest can have lending fees that are roughly comparable to prevailing interest rates on savings accounts and other short-term investments. However, popular short candidates can carry lending fees of double-digit or even triple-digit percentage rates -- making them extremely expensive to short.
  • If you end up having to borrow money through a margin account in order to maintain your short position, then you'll also typically owe interest on the amount you borrow from your broker. Brokers' margin rates vary, but in some cases, they can be quite a bit higher than what you'd pay on a typical mortgage or car loan.
  • Finally, if you sell a stock short that pays dividends to its shareholders, you have to pay the dividends on shorted shares if the company you're shorting declares any during the period that you've borrowed shares. That way, the investor who lent you the shares will end up being made whole for the dividends they would've received if you hadn't borrowed the shares and sold them short. It can come as a shock to some short sellers that they have to pony up cash when a stock pays a dividend -- even though the short seller didn't actually receive the dividend on the shares.

When you take all the costs involved with short selling into account, they can sometimes turn what would've been a net profit into a net loss. It's important to recognize the role that costs play in the short selling strategy, because sometimes, a high-cost short won't be worth taking on if you don't think that the potential profits from the expected decline in the stock price will be enough to offset your related expenses.

Is short selling evil?

Last but not least, investors need to understand that there's a certain stigma attached to short selling. Investors who think that a certain stock is destined to go up in price will naturally disagree with those trying to profit from a share-price decline. You'll often hear allegations going back and forth about how short sellers manufacture negative arguments about a company in order to force its share price to drop -- thereby making their short positions profitable. Many opponents of short selling have an almost moral or ethical objection to the practice.

There's nothing inherently evil or wrong about selling a stock short. Just as owners of a stock who want to see its price rise over time will tout the potential positives that a company has, so too do short sellers sometimes express their skepticism about the riskier elements of a company's business. Most economists believe that short sellers serve a useful function of providing a balance against the generally bullish sentiment that most major financial institutions have. Just don't be surprised if some investors seem to respond with scorn when you talk about your short positions.

Be careful with short selling

Short selling can be a lucrative way to profit if a stock drops in value, but it comes with a lot of risk. Because there's no inherent limit to the amount that a share price can rise, the potential losses involved with short selling can dramatically exceed your ability to absorb such losses. Only by being aware of the full extent of the risks of short selling can you manage your portfolio in a way that balances those risks against the huge rewards that you can make if your short position turns out to be the correct one.