This blog will start the same way it ends - with a warning concerning the subject matter: Short selling is not for the inexperienced and faint-hearted investor.
Fundamentally, short selling is a way to invest so that you profit when the price of a security declines. Rather than buying a stock (called going "long") and then selling later, going short reverses that order. A short seller borrows stock from a broker and sells that into the market. Later, they hope to buy back that stock at a cheaper price and return the borrowed stock in an effort to profit on the difference in prices.
For those electing to take the plunge, the first step is to establish a margin account on your brokerage account. This will allow you to borrow money to short a stock. There needs to be enough margin capacity to support the loan, on which you'll pay interest. In addition, there's a fee paid to the broker for the service of finding stock to sell short. Lastly, you're on the hook for any dividends paid by the company. The interest cost, fee, and dividends are all rolled into your margin balance.
Probably the most important aspect of the process is selecting the right stock to short. This should only be done after extensive research and analysis. There should be powerful fundamental reasons why you are placing a bet in anticipation of a company's stock declining. To short a stock, you'll place an order to sell stock that you don't own. The short position will typically show up in your account as a negative number of shares (e.g., - 100 shares of XYZ stock). Ideally, the stock you shorted will decline in value, if not outright take a severe swoon. As the investor, you'll have to decide when to close the position and at what price. When you're ready to push the button, you buy the stock. This will automatically close out the negative short position. The difference in your sell and buy prices is your profit (or loss).
Short selling can offer some positives. First and foremost, an astute investor can make money when they discover an overvalued stock that comes back to earth in terms of valuation. It provides another tool in the investor's tool kit. Short selling also helps keep fraudulent companies from ripping off investors. Because of the intense research involved, short sellers can at times dig up financial information and data overlooked by long/passive buyers. Markets tend to be more orderly and function better when short sellers are in the mix. Besides providing liquidity for buyers, long-term investors can buy at more stable prices and amass stakes at lower prices. Lastly, shorting offers excellent hedging opportunities. Investors can sell their profitable positions for cash in a market drop, and then add to their long positions at lower prices.
Of course, short selling has its share of detractors and disadvantages. Since the stock market as a whole tends to go up over time, short sellers face a situation that's already stacked against them in the long run. Another potential hurdle is the fact that you can experience unlimited losses in the event the stock you've shorted keeps rising. You could lose more than you put into the trade since your risk is theoretically uncapped. Also, as mentioned earlier, there are ancillary costs involved with the short selling process. Lastly, and it primarily comes from less than knowledgeable investors, but there's often skepticism, animosity, and unfavorable stigma associated with short sellers. America admires success, and short sellers are betting against success.
I would be remiss if I didn't touch on a recent notorious "short squeeze" scenario. Specifically, the situation involving video game retailer GameStop in early 2021. A short squeeze occurs when the stock rises rapidly, forcing short sellers to close their position. As the short squeeze hurts more and more short sellers, they are forced to buy stock at any price, pushing the price still higher. This nightmare played out for short sellers of GameStop stock in 2021. Led by a basement-dwelling cretin known on the Internet as "Roaring Kitty," masses of small, novice investors put the screws to some hedge funds who had wisely shorted GameStop. There was no fundamental financial reason to bid up the price of GameStop. I found the whole incident disgusting. These small investors, if you can even call them that, were not heroes. They were nothing more than idiotic "pumpers and dumpers."
Personally, or as a fiduciary, I've never technically sold a stock short. I harbor no philosophical reservations about doing so, however. Lack of doing so is primarily attributable to a reluctance to establish a margin account and the various costs associated with the short selling process. That said, I have "effectively" shorted certain stocks and indexes by purchasing put options - with mixed results. One challenge, as mentioned previously, and it's especially been the case during this long-running bull market, is that stocks can stay irrationally overvalued for a surprisingly extended period. Long enough to test the solvency and patience of many investors taking a short position. My advice would be to favor put options over short selling, favor indexes over individual stocks, and to place short bets exclusively for hedging purposes. As promised at the onset, I end with this reminder: pure short selling is not for the inexperienced and faint-hearted investor.
