Hedge funds are among the most active short-sellers and often use short positions in select stocks or sectors to hedge their long positions in other stocks. Though short selling does present investors with an opportunity to make profits in a declining or neutral market, only sophisticated investors and advanced traders should attempt it due to its risk of infinite losses.
Short selling is not a strategy many investors use, largely because the expectation is that stocks will rise in value over time. In the long run, the stock market tends to go up, although it is occasionally punctuated by bear markets in which stocks tumble significantly. For the typical investor with a long-term investment horizon, buying stocks is a less risky proposition than short selling.
Short selling may only make sense in certain situations, such as in a protracted bear market or if a company is experiencing financial difficulties. That said, only advanced investors who have a high tolerance for risk and understand the risks associated with short selling should attempt it.
Trading commissions are not the only expense involved when short selling. There are other costs, such as:. Yes, you can lose much more than you have invested in a short sale; in theory, your losses can be infinite. This is the reverse of a conventional "long" strategy, by which the maximum gain on a stock you have purchased is theoretically infinite, but the most you can lose is the amount invested.
As an example of the devastating losses that can be inflicted on a short sale by runaway price appreciation, consider this situation. An investor who had a short position of shares in GameStop as of Dec. Short selling has acquired a negative connotation because some unscrupulous short sellers have used unethical tactics to drive down stock prices. But when used in the correct manner, short selling facilitates the smooth functioning of financial markets by providing market liquidity, acting as a reality check for investors' unrealistic expectations and thus reducing the risk of market bubbles and enabling downside risk mitigation.
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I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Table of Contents Expand. Example of a Short Sale. What Are the Risks? Why Do Investors Go Short? Unlike buying and holding stocks or investments, short selling involves significant costs, in addition to the usual trading commissions that have to be paid to brokers.
Some of the costs include:. Margin interest can be a significant expense when trading stocks on margin. Since short sales can only be made via margin accounts, the interest payable on short trades can add up over time, especially if short positions are kept open over an extended period. As the hard-to-borrow rate can fluctuate substantially from day to day and even on an intra-day basis, the exact dollar amount of the fee may not be known in advance.
The short seller is responsible for making dividend payments on the shorted stock to the entity from whom the stock has been borrowed. The short seller is also on the hook for making payments on account of other events associated with the shorted stock, such as share splits, spin-offs, and bonus share issues, all of which are unpredictable events.
Two metrics used to track short-selling activity on a stock are:. Both short-selling metrics help investors understand whether the overall sentiment is bullish or bearish for a stock. For example, after oil prices declined in , General Electric Co. Timing is crucial when it comes to short selling.
Stocks typically decline much faster than they advance, and a sizeable gain in a stock may be wiped out in a matter of days or weeks on an earnings miss or other bearish development. The short seller thus has to time the short trade to near perfection. On the other hand, entering the trade too early may make it difficult to hold on to the short position in light of the costs involved and potential losses, which would skyrocket if the stock increases rapidly.
There are times when the odds of successful shorting improve, such as the following:. The dominant trend for a stock market or sector is down during a bear market. Short sellers revel in environments where the market decline is swift, broad, and deep—like the global bear market of —because they stand to make windfall profits during such times.
For the broad market, worsening fundamentals could mean a series of weaker data that indicate a possible economic slowdown, adverse geopolitical developments like the threat of war, or bearish technical signals like reaching new highs on decreasing volume, deteriorating market breadth. Experienced short-sellers may prefer to wait until the bearish trend is confirmed before putting on short trades, rather than doing so in anticipation of a downward move. This is because of the risk that a stock or market may trend higher for weeks or months in the face of deteriorating fundamentals, as is typically the case in the final stages of a bull market.
Short sales may also have a higher probability of success when the bearish trend is confirmed by multiple technical indicators. A moving average is merely the average of a stock's price over a set period of time. If the current price breaks the average, either down or up, it can signal a new trend in price. Occasionally, valuations for certain sectors or the market as a whole may reach highly elevated levels amid rampant optimism for the long-term prospects of such sectors or the broad economy.
Rather than rushing in on the short side, experienced short-sellers may wait until the market or sector rolls over and commences its downward phase. John Maynard Keynes was an influential British economist whereby his economic theories are still in use today. The optimal time for short selling is when there is a confluence of the above factors.
Sometimes short selling is criticized, and short-sellers are viewed as ruthless operators out to destroy companies. However, the reality is that short selling provides liquidity, meaning enough sellers and buyers, to markets and can help prevent bad stocks from rising on hype and over-optimism. Evidence of this benefit can be seen in asset bubbles that disrupt the market. Assets that lead to bubbles such as the mortgage-backed security market before the financial crisis are frequently difficult or nearly impossible to short.
Short selling activity is a legitimate source of information about market sentiment and demand for a stock. Without this information, investors may be caught off-guard by negative fundamental trends or surprising news. Unfortunately, short selling gets a bad name due to the practices employed by unethical speculators. Most forms of market manipulation like this are illegal in the U. Put options provide a great alternative to short selling by enabling you to profit from a drop in a stock's price without the need for margin or leverage.
If you're new to options trading, Investopedia's Options for Beginners Course provides a comprehensive introduction to the world of options. Its five hours of on-demand video, exercises, and interactive content offer real strategies to increase consistency of returns and improve the odds in the investor's favor. Unexpected news events can initiate a short squeeze which may force short sellers to buy at any price to cover their margin requirements.
For example, in October , Volkswagen briefly became the most valuable publicly traded company in the world during an epic short squeeze.
In , investors knew that Porsche was trying to build a position in Volkswagen and gain majority control.
Short sellers expected that once Porsche had achieved control over the company, the stock would likely fall in value, so they heavily shorted the stock.
A short position is one that bets against the market, profiting when prices decline. To sell short is to take such a bet.
This is opposed to a long position, which involves buying an asset in hopes the price will rise. You cannot sell something that doesn't exist, Since a company has a limited number of shares outstanding, a short seller must first locate some of those shares in order to sell them. The short seller, therefore, borrows those shares from an existing long and pays interest to the lender. This process is often facilitated behind the scenes by one's broker. If there are not many shares available for shorting i.
While some people think it is unethical to bet against the market, most economists and financial professionals agree that short sellers provide liquidity and price discovery to a market, making it more efficient. Many brokers allow short selling in individual accounts, but you must first apply for a margin account. Because short sales are sold on margin, relatively small losses can lead to ever larger margin calls. If a margin call cannot be met, the short must buy back their shares at ever higher prices.
This works to bid the price of the stock even higher. General Electric. Porsche SE. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page. These choices will be signaled globally to our partners and will not affect browsing data. We and our partners process data to: Actively scan device characteristics for identification.
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Updated: Oct 12, at PM. Matt specializes in writing about bank stocks, REITs, and personal finance, but he loves any investment at the right price. Follow him on Twitter to keep up with his latest work! Image source: Getty Images. Join Stock Advisor Discounted offers are only available to new members.
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