Shorting a Stock: Seeking the Upside of Downside Markets

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.

What Does It Mean to Short a Stock?

You’re probably familiar with the terms “short selling,” “going short the stock market,” “shorting a stock,” or “selling stocks short.” The aim when shorting a stock is to generate profit from stocks that decline in value. There are potential 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 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 shorting stocks as part of an investment strategy 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) and only appropriate to those who are comfortable with the inherent risks.

How Does Short Selling Work?

Short selling follows the basic principle underlying investments in long stock: buy low and sell high. But a short sale works backward: 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. Here’s an example.

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

To Sell Stocks Short, You Need to Open a Margin Account

Some investors and traders use margin in several ways. 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.
• 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.

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.

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 help hedge a number of related sector stocks that you may be holding in your portfolio.
3. Playing both sides of the market. You can consider going long on stocks you expect to outperform while going short on stocks that you expect to underperform. You could even consider buying (going long) and selling (going short) two highly correlated stocks that have moved 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. Because there is technically no limit to how high a stock or ETF price can rise, your risk of loss in short selling is 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 Stocks?

With proper risk management techniques, shorting stocks 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 trading page.