Short-selling is a way to make money when stocks decline. While the process is easy enough in theory, short-selling is usually the province of sophisticated, well-informed, and (often) well-funded investors. That’s because the market tends to go up over time, and short-sellers have a position that benefits only if the market goes down, so an investor needs nerves of steel and a lot of capital to withstand a rising market.

Here’s what you should know about short-selling.

How short-selling works

In a literal sense, short-selling or “going short” is the opposite of buying a stock or “going long.” When you go long, you buy a stock, wait for it to rise (fingers crossed!), and then sell at a higher price. In a short sale, you reverse those steps:

1. Sell the stock (after first borrowing it from the broker).
2. The stock goes down or up.
3. You buy back the stock and close the trade.

The short sale simply inverts the order of the buying process, with the investor selling stock first and buying it back later. If the stock falls below where the investor sold, the difference is profit. If not, the short-seller has to buy back those shares for more than was paid, resulting in a loss.

Unlike buying a stock, where your loss is limited to whatever you invest, short-selling exposes investors to potentially uncapped losses.

Unlike buying a stock, where the upside is theoretically unlimited, the maximum gain on a short position is the total value of the short position. If you short 100 shares of a $100 stock, your maximum gain on the position is $10,000, if the stock went to zero.

It’s a much different situation for the potential loss, however, which is theoretically unlimited. If the stock keeps rising, the short position keeps losing money. If you lose enough money on a short position and don’t have enough equity (net value) in your account, the brokerage could issue a margin call requiring you to put more equity (cash) into the account. If you’re unable to do this, the brokerage will close your positions until there is enough equity in the account.

The most important point is this: unlike buying a stock, where your loss is limited to whatever you invest, short-selling exposes investors to potentially uncapped losses. Short-sellers can lose more than they put into a trade, and that’s enough to keep many new investors away.   

How do you borrow stock to short-sell?

Virtually any online brokerage will allow you to short stock, and the first step is borrowing stock. This is easy to do, because the brokerage does it behind the scenes on your behalf when you set up a short sale, technically borrowing the stock from another investor. Short-sellers then simply specify that they’re making a short sale on the trade ticket, similar to how they indicate that they’re buying stock.

However, to borrow stock you’ll need a margin account with the brokerage. A margin account allows you to take a loan from the brokerage based on the net value of your account. So when you borrow stock to open a short position, you’re effectively taking a loan. When you short the stock, you raise cash, but that cash is actually still on loan from your broker. And like all margin loans you’ll pay interest on it, at whatever the brokerage’s margin rates are.

Short-sellers have another cost — the cost of borrow, as it’s called. Typically it costs a few percent annually of the total asset value to borrow a stock via your broker, and some of this fee often goes to the stock’s owner as an incentive to lend the stock. For popular short stocks, however, the cost of borrow could zoom, perhaps higher than 20%. On these trades, going short quickly becomes an expensive proposition, and it costs a lot of money to maintain the position.

What else do short-sellers need to know?

The points above are the most important, but there are still other things that short-sellers must know and even more costs associated with short-selling.

1. To even make the trade, short-sellers need at least 50% of the short stock’s value as equity in the brokerage account, either as stock or cash.
2. To maintain the short position, the stock exchanges require the investor to hold at least 25% of the short stock’s value as equity, either as stock or cash. Individual brokerages may require even higher amounts. Dip below this level and they’ll issue a margin call, forcing you to add more equity to your account.  
3. While they do receive cash from short sales, short-sellers may not spend that cash.
4. If an investor is short a stock while the stock has paid a dividend, the investor must pay that dividend back to the owner. In practice, this means that the dividend is simply tacked on to the investor’s margin loan.

That’s complicated, for sure, but there’s one more complication that’s the stuff of nightmares.

The nightmare for short-sellers

More than anything short-sellers dread what’s called a “short squeeze.” This happens from time to time in the market when a stock spikes higher (perhaps because of good news or a great earnings report), forcing some short-sellers to close their positions by buying stock. Then this buying moves the stock up even more, forcing even more short-sellers to buy back their stock. It can turn into a nasty chain reaction, and sometimes the stock skyrockets as part of a squeeze.

A short squeeze can sometimes be gut-wrenching because if the stock moves higher fast enough, some short-sellers may lose much more than they have in their account. Even if the stock ultimately goes to zero, short-sellers can be forced out of their positions. There’s an old saying on Wall Street: “The market can remain irrational longer than you can remain solvent.”

So that’s why short positions are usually a relatively small part of most investors’ portfolios.

Still interested in short-selling?

Because short-selling is relatively complicated and potentially riskier than going long stocks, most investors stay away from it, leaving it to the pros. But there’s a great way to test it out, with no risk at all — try your hand at “paper trading” using virtual money on the Wealthbase simulated stock trading game, so you can get a feel for how it works. It’s easy to get started.