In the long run, the odds are that the average stock will rise in value over time, which is why for many of us in the U.S., stock investments are our primary means of investing for retirement. That, of course, doesn't mean that individual stocks can't fall in value. Often, the best response to these iffy stocks is simply to avoid buying them. An alternative is to invest in the stock in a way that makes money when the price drops, a process called "shorting." There are a few different ways to make money on a falling stock price and reasons why you should be cautious about doing it.
What Is Short Selling of Stocks?
When you place a short sale order with your broker, you're not selling stock you presently own. Instead, you're entering into an agreement with your broker to sell a stock you don't yet own. To make this possible, you borrow the stock from your broker; it's this borrowed stock that you're selling.
An intrinsic part of every short sale is the agreement between you and your broker that at some future time you'll return the stock you've borrowed. If the share price of the stock you've borrowed subsequently drops, your short sale is profitable. The term for this is "closing out the short."
To see how this works in practice, imagine that on October 23, 2017, you short 1,000 shares of JCPenney Company Inc. (symbol JCP). At the time you short it, the price is 3.75 per share, so you've committed $3,750 to the short sale.
There are good reasons for executing this short: Retailers like JCPenney and Sears have been in hot water for years and more so since Amazon entered the retail market. Over the four-year period preceding the date you shorted it, Penney's stock value has steadily declined from around $18 to $3.75 per share.
Sure enough, by November 3rd, the stock had fallen to $2.37 per share. At this point, you buy 1,000 shares at this new price, return the stock to your broker (this happens automatically), which closes out your short with a profit of $1,380, the difference between the stock's price of $3.75 on the date you borrowed the stock and the price of $2.37 on the date you return it.
How to Short a Stock
To short a stock, you'll need a margin account that allows you to buy stock with funds borrowed from your broker.
Open the trading page for your account, where you'll enter the symbol for the stock you're selling short. You'll next have a choice between "selling," "buying" or "selling short." Choose "selling short." Next, enter the desired number of shares and the order type, where you'll have a choice of "market," "limit" or "stop limit." You can choose any of these options, but in this instance you'll select "market," which means that within a very short period of time – sometimes within a fraction of a second of your confirming your order – you'll have sold the stock short, thereby agreeing that at some future time you'll return the stock you've borrowed at the market price at the time you executed the short sale.
The final choice you'll need to make before confirming the order is whether you want the order you're placing to be "good until canceled" or "day only." There's no right or wrong choice here, although with short sales if they don't go through on the day you've executed the trade, you might want to take another look to understand why before allowing the order to execute on another day. If so, choose "today only," and confirm the trade. That's it! You've executed a short sale.
How to Short a Stock with Options
The problem with a short sale transaction, whereby you borrow from your broker and sell on the market in the hope that the share price will decrease and you'll be able to buy them back at a lower price, is that your potential losses are unlimited. There's another way to benefit from a falling stock price that reduces your risk and as an added a benefit does this without tying up as much of your money, namely, by buying a put option.
To trade in options, you'll have to apply for that right through your stockbroker. In most cases, the process is uncomplicated: You fill out a short request form that your broker provides and satisfy the account minimum, which in most cases is $25,000.
Buying a put option gives you the right, but not the obligation, to sell the stock at the "strike price" before the expiration of the option.
A "strike price" is different from a market price in that it has no direct relationship to the stock's present value. Instead, it's a price you choose. Put options on most stocks come with several different strike prices and many different expiration dates. You can buy a put option on stock you own or on stock you don't. In the latter case, you're usually doing this to accomplish something similar to shorting a stock, but with far less risk.
For instance, instead of selling short 1,000 shares of JC Penney, you could have bought an option to sell the stock at a "strike price." Option trading gets complicated quickly, but to keep things simple, suppose that on November 23, 2017, you buy put options on 1,000 shares at a strike price matching the current price of $3.75 and with a 30-day expiration date. On November 3rd, you can buy these 1,000 shares at the November 3rd price of $2.37, and then sell them at the guaranteed strike price of $3.75, making the same profit you would have made by shorting, less the cost of the option. You've also done this with far less risk. When you buy a put option, the most you can lose is the cost of the option. If the price of the stock during the option period never falls below the strike price, you simply allow the option to expire.
Pros and Cons of Short Sales
There's a seeming symmetry in selling long and selling short. Either way, you'll make an amount of money that equals the difference between the value of the stock on the day you execute the order and the day you sell it.
There are also some critical differences, enough that prompt some investment professionals to warn against short selling entirely. While that may be a bit extreme, the dangers are worth noting:
Historically and over the long run, the stock market has gradually moved upward. The average long-term gain over more than 100 years has been around 10 percent a year. This doesn't mean you're necessarily going to lose money by shorting either a stock or even the overall market, but it does mean that the odds are just a little worse than if you'd bought long.
Also, when you buy a stock long, even if the stock price drops to zero, you can't lose more than whatever the stock cost you when you bought it. With a short sale, on the other hand, your potential losses are potentially infinite; the stock price could climb upward forever. In reality, that won't happen, but as the price of your shorted stock rises, at some point, your broker is going to give you two choices: the choice of losing the difference between the price when you bought it and its current higher price, meaning you'll be closing out the short with that loss, or the choice of adding more cash to your account to adequately cover the loss.
If you're stubborn or convinced that eventually you'll be proven right, this process can continue repeatedly. It can happen to the most sophisticated investors. Billionaire William Ackman, one of Wall Street's most successful investors, finally closed out his short on Herbalife in 2017 after losing more than $10 million after the stock, which most investors predicted to lose value significantly, gained 50 percent instead.