Shorting a Stock: Seeking the Upside of Downside Markets

Short selling aims to provide protection or profit during a stock market downturn, but it can be risky. Plus it requires a margin account. Learn the mechanics of shorting a stock.

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5 min read

Key Takeaways

  • Short selling aims to profit from stocks that decline in value
  • Short selling requires margin account privileges
  • Learn the mechanics, and the potential benefits and risks, of shorting a stock

If anything is certain about the markets, it’s that they fluctuate. They go up and they go down. Bull markets and bear markets. It’s like traveling a mountain range, across peaks and valleys. Sure, over longer periods, the upward cycles in the stock market tend to be larger than the downward cycles, but many of the downturns have been steeper and faster. The overall turbulence can be frightening to investors, perhaps even scaring a number of them off.

Perhaps you’re wondering if there’s any way to capture the upside during a market downturn, or more specifically, any way to profit when a stock, sector, industry or the broader market enters a short-term correction or a longer-term bear market. The answer, with a few caveats that we’ll explore, is yes. Investors can profit from a market decline.

Enter the “Shorts”

You’re probably familiar with the terms “short selling,” “going short the stock market,” ”shorting a stock” or “selling stocks short.” Short selling aims to generate profit from stocks that decline in value. There are benefits to going short, but there are also plenty of risks.

We also can’t neglect the stigma attached to short selling. After all, shorting a stock is all about generating profit from a company’s partial or total decline. But short sellers play an important role in the a healthy market—the matching of buyers and sellers, and providing liquidity and price discovery to the market.

So if you’re new to this way of investing and would like to learn more, let’s start by exploring the basic mechanics of a short sale.

But a word of caution: the short selling strategy is available only to investors with margin trading privileges (more on that below), who are comfortable with the inherent risks.

How Does Short Selling Work?

Short selling follows the basic principle underlying all investments: buy low and sell high. But a short sale works backwards: sell high first, and (hopefully) buy low later. But how can you sell a stock that you don’t already own?

You “borrow” it from another investor with the help of your brokerage firm.

Shorting a stock—a hypothetical example:

  • You place an order to sell short 100 shares of stock XYZ at the price of $40.
  • Your broker “borrows” the shares, fills your order, and places them into your account; you are now “net short” $4,000 worth of XYZ stock (100 shares at $40 = $4,000).

Favorable scenario:

  • Stock XYZ falls in price to $35.
  • You sold at $40 and decide to “buy” back at $35 to close your position, pocketing the difference of $500 (100 shares at $5) minus any transaction costs.

A word on dividends: If the company paid any dividends during the time you were short, your account would be reduced by the amount of the dividend. Why? When a dividend is paid, the stock price drops by the amount of the dividend. For example, if a stock is at $40 and the company pays a $1 dividend, the owner of record gets the $1, and the stock value is reduced, all else equal, to $39. So if you held a short position on the ex-dividend date, you would get the benefit of the stock drop, but you essentially “pay” the dividend. In and out.

Not-so-good scenario:

  • Stock XYZ rises by $5 to $45.
  • This position has moved against you, as you sold short at $40 and now have to buy it back at a higher price. You decide to buy at $45, losing $500 (100 shares at $5) plus any transaction costs, as well as any dividends you might have paid along the way.

In a nutshell, that’s how short selling works.

But there’s one more step that might make things slightly more complicated.

To Shell Short, You Need to Open a Margin Account

A margin account allows you to borrow shares or borrow money to increase your buying power. In this case you can sell short marginable stock with up to twice the buying power of a traditional cash account. The securities you hold in your account act as collateral for the loan, and you pay interest on the money borrowed.

  • To qualify for a margin trading account, you need to apply, and you must have at least $2,000 in cash equity or eligible securities.
  • And when you use margin, you must maintain at least 30% of the total value of your position as equity at all times. If market fluctuations reduce the value of the equity in your account, your broker may issue a margin call, which you must meet by adding funds to your account. If you fail to meet a margin call, your broker could buy back your short position.

The traditional margin trading example is summarized in figure 1.

FIGURE 1: TD AMERITRADE MARGIN EXAMPLE. For illustrative purposes only.

Margin accounts and margin trading can be risky, so it’s important to understand the risks before you jump in. If, you're interested in applying for margin trading privileges, log in to your account and follow the instructions in figure 2 below.

FIGURE 2: APPLYING FOR MARGIN PRIVILEGES. Log in to your account at tdameritrade.com and under My ProfileElections & Routing > Margin trading check to see if margin trading is enabled. If not, a green Apply button will appear. Source: TDAmeritrade.com. For illustrative purposes only.

Potential Benefits and Risks of Short Selling

Let’s start with the potential benefits:

  1. Profiting from downturns: Short selling allows you to seek positive returns during a market downturn.
  2. Hedging your “long” positions: You can use short selling to hedge stocks you already own. For instance, you can short a sector ETF to protect a number of related sector stocks that you may be holding in your portfolio.
  3. Playing both sides of the market: You can go long stocks you expect to outperform while going short stocks that you expect to underperform (or going long and short two highly correlated stocks that may have moved too far apart and that you expect to converge). 
  4. Diversifying a portfolio: If a portfolio is completely made up of long positions, a margin account could allow you to further diversify in a market downturn (what's known as "systematic risk") by having both long and short positions. Also, if your portfolio is dominated by a large position in one stock, a margin account could allow you to diversify your portfolio without having to sell your current shares of stock. This strategy can be particularly helpful if you have a large unrealized capital gain and want to try to keep it that way.

And now, a few of the risks:

  1. Unlimited risk. Since there is technically no limit to how high a stock price can rise, your risk in shorting a stock is virtually unlimited.
  2. Dividends and other payments. You’re responsible for any dividends, stock splits, or spin-offs paid on the borrowed stock.
  3. Unfavorable liquidation. You may be required to close your short positions at unfavorable prices, particularly in cases where your stock experiences a sharp surge in price.
  4. Historical upward trend. Historically, the broader stock market has risen over time. Though past performance is no guarantee of future results, the market’s tendency to rise over time remains a potential risk for any short seller.

To Short or Not to Short?

With proper risk management techniques, short selling can potentially enhance your investment strategy. But it isn’t for every investor.

If you’re not sure whether short selling or margin trading might be appropriate for your financial profile, risk tolerance or financial goals, contact a representative for assistance in making the assessment. For additional videos, resources and support on margin trading, visit this TD Ameritrade margin page or watch the video below.

Short selling allows you to sell something you don't own, so traders must understand the regulatory requirements. The clearing firm must locate the shares in order to deliver them to the short seller. Shares may be hard to borrow because of high demand, a small number of outstanding shares ("float"), or increased securities volatility. If the stock loan department is unable to deliver the shares for settlement, it may call for a “buy-in,” meaning the borrower must buy the shares in the open market to cover the position. If the stock price has increased, the borrower will lose money. 

Also, borrowers of certain “hard-to-borrow” (HTB) shares may be subject to an additional fee in order compensate the stock loan department for the cost of locating and maintaining its supply of such HTB shares. If you open and close a short position intraday (meaning you don’t hold it overnight), you will not be subject to a fee. However, if you hold the position longer, an HTB fee, based on the notional value of the short position and the annualized HTB rate, will be assessed.

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Margin trading increases risk of loss and includes the possibility of a forced sale if account equity drops below required levels. Margin is not available in all account types. Margin trading privileges subject to TD Ameritrade review and approval. Carefully review the Margin Handbook and Margin Disclosure Document for more details. Please see our website or contact TD Ameritrade at 800-669-3900 for copies.   

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