When it comes to investing, you’re normally trying to buy low and sell high. But some advanced traders and portfolio managers may actually want to sell high and buy low.
Not sure about the difference?
When you buy low and sell high, you’re making a bet that a company or fund will be worth more than the price you paid for it. This mindset paired with a buy-and-hold strategy, where you hold onto stocks for years or decades, is how many financial experts, including Warren Buffett, recommend investors build wealth through the stock market. (And it has proven to be a successful strategy for the billionaire investor.)
When you sell high and buy low, though, you’re betting that a company or fund will actually fare worse in the future. This act, called short selling or “shorting,” can be a risky and expensive bet to make because it can potentially lead to large losses.
What’s the definition of short selling?
Short selling is a speculative form of investing that allows you to borrow and sell shares of an investment that you think will go down in value. You make money if the stock value goes down and you can buy back the number of shares you borrowed at a lower price than you sold them at.
Take this example: You “borrow” and sell 100 shares of Company XYZ, which is currently valued at $100 a share. Then you put the $10,000 proceeds into your margin account (a type of brokerage account that holds cash for these kinds of transactions). Your instinct pays off and the cost of XYZ plummets to $80. You’re then able to buy up 100 shares for $8,000, meaning you’ve made a profit of $2,000 by the time you return those 100 shares of XYZ.
Of course, this type of bet isn’t without its risks. You could lose money if the price goes up and you’re forced to buy the same number of shares at a higher cost.
Say that Company XYZ actually exceeds all of your expectations and rises to trade at $120 a share. If the lender of the shorted shares requests those 100 shares back, you’ll now be forced to buy back 100 shares for $12,000, at a loss of $2,000.
What can make short selling particularly dangerous is when big increases happen and people suddenly owe drastically more money than they made originally selling borrowed stock.
What are the costs of short selling?
With short selling, you don’t only lose money when your borrowed stock goes up in value. Your broker will generally charge some sort of fee or commission in exchange for setting you up with borrowed shares. You may also owe interest to the person or institution that’s loaning you those shares for the duration of the time you have them.
All this is to say, when you short sell, you’re betting you will make enough profit to make any commissions or interest payments worth it.
How do you short sell?
You generally short sell through a broker-dealer, or a company that trades securities for customers. Most major brokerages allow customers to short sell.
How long can you wait to buy the shorted shares back?
There’s no standard regulation on how long a short sale can last before being closed out, meaning the investor returns the share to the lender. But the lender of the shares does have the ability to request that the shares be returned at any time, without much notice. If that happens, the short sale investor must return the shares to the lender regardless of whether the price has gone up or down. So that means the investor may end up taking a loss on the trade.
Why would someone short sell?
The same reason someone would trade stocks in general: a hunch that a certain company or fund will do better (or worse) than it’s currently doing.
Some professional investors or fund managers may short sell to “hedge” their investment portfolios. This lets them make sure that even if certain asset classes dip that they’ve reduced the likelihood they’ll lose a lot of money because they’re betting some money on success and some on failure.
Should I short sell?
Short selling carries with it tremendous risks. If you’re a regular investor trying to save for retirement, educational costs, a down payment or another large purchase, you’re probably best served by investing in a portfolio of low-cost, diversified index funds, like exchange-traded funds (ETFs). When you invest broadly through ETFs, you achieve a similar kind of portfolio diversification, or hedging, that professional investors and fund managers are looking for when they short sell. (Acorns portfolios offer exposure to thousands of stocks and bonds. Learn more.)
Historically, over the long term, a diversified, buy-and-hold type of investment strategy has rewarded investors with steady, strong performance with considerably less risk than active trading or short selling. While the type of short-term losses short selling takes advantage of are virtually inevitable, historically, over the long term, the market has grown exponentially over time. Low-cost, diversified index funds and ETFs and regular investing through dollar-cost averaging position passive investors to benefit from these historic gains over the long run.
If you choose to short sell in addition to your primary investment portfolio, make sure you aren’t shorting quantities of shares that could cost you more than you can afford to lose. Remember: With short selling, there’s really no limit to the amount of money you can lose. When you trade individual stocks, you can only lose the amount you pay for a share. With shorting, you can lose exponentially more, if a stock’s value grows quickly.
Investing involves risk including loss of principal. This article contains the current opinions of the author, but not necessarily those of Acorns. Such opinions are subject to change without notice. This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.