What is Shorting and How it Works? (With Examples)

What is shorting? When talking about shorting or short selling, in a nutshell, it means betting the price will fall. For example, if the stock you shorted falls 1% your short position gains 1%.

How short selling works?

Like I said, shorting or short selling a stock, index, whatever ever comes to mind, means you are betting against it. By this I mean betting it will fall. If the instrument you are shorting falls by 1%, you gain 1% for your short position if you didn’t use any leverage.

Leveraging means you can short something with 2x leverage. This means that if the stock you shorted, falls 1%, your position gains 2%. This applies to both sides. If the position you are shorting happens to rise 1% and you have a 2x leveraged short position, your position will be down 2%.

Short selling works pretty much like this: Joe thinks Example Stock will fall, because it has had a rough past few months. He borrows one stock from his neighbor and sells it to the market for 100 dollars.

A week later, the stock has fallen 10% and it is now at 90 dollars. Joe buys the stock back from the market and gives it back to his neighbor. By doing so, Joe pocketed 10 dollars from this short position.

In reality, it isn’t this hard to short sell stocks. There are many instruments that you can use to short with or without leverage. I will return to them later in this post.

Downsides of short selling

Downside with short selling is that there is “unlimited” losing potential. This means if you buy or take a long position on a stock, it can only fall to zero. However, when shorting, it can basically rise forever, and if you happen to have a short position with a stock that is facing a huge rise, your loss potential is unlimited.

Let’s take Joe again as an example. Joe again borrows stock from his neighbor. He thinks the stock will fall because it has had a rough month. Joe sells the stock to the stock market for 100 dollars.

The very next day, the company reports really good sales numbers, and the stock price rises to 300 dollars. Joe and his neighbor made a deal, that Joe would return the stock the next week, so Joe is forced to buy the stock back for 300 dollars. Joe buys the stock, returns it to his neighbor, and walks away with a 200-dollar loss.

What is short squeeze

We have seen some short squeezes in the market over the past year or so. Short squeeze means, if someone is shorting a stock, people know it and they want to put the shorter through a hard time. They will pump the stock, meaning try to raise its price to force the short seller to buy the stocks back at a higher price. By doing so, the short sheller will be short-squeezed and might have to take huge losses.

Let’s bring good old Joe for an example. Joe once more borrows the stock from his neighbor. Joe is sure that the company will report bad numbers and the stock will fall. He sells the stock for 100 dollars. Chris finds out about Joe’s short position and decides to squeeze some money out of Joe’s pocket.

The company reports bad numbers, but Chris is buying the stock with all of his savings. Chris has deep pockets and manages to raise the stock price to 500 dollars. Joe panics and buys the stock back for 500 dollars, because he is afraid it would rise even more. Chris successfully short squeezed Joe and made him take a 400 dollar loss.

Hedge your long positions with shorting

You can protect your long positions with short term short positions if you think the market is going to fall. By doing so, you don’t have so sell your long positions and pay taxes for those wins. You keep the long positions you have and take a short position as well. This way, no matter the direction the market is going, you won’t gain or lose money if your short is equal to your long position.

Remember, if you decide to do this, if the market happens to rise, you wont be benefiting from those gains. On the other hand, if the market falls, you wont be taking the hit since you have a short position to cover the losses you face. This can be a more tax-efficient way than just selling your long positions.

How to sell short

Nowadays, there are a lot of different ways to short stocks, indexes, or pretty much anything. You can also get very high leveraged products, at least up to 200x. Meaning, if the stock you shorted rises by 0,5%, your position is down 100%.

Easiest way to short, I would say is to open a broker account that offers CFD products. This is a simple way to short or long anything with leverage. You could also short with other instruments such as options. Options are a bit more complicated, but just know that there are a lot of different ways to short. Keep in mind that when ever you use leverage on your positions, the risks will be much higher.

Shorting is riskier than just taking long positions. Since the stock market has typically made an 8% inflation-adjusted return, if you kept your shorts for a longer period of time, the chances are you would lose.

If this happened to light up your interest in the world of shorting, start with smaller amounts of money. Don’t short the market with all your savings just because your taxi driver told you he is sure that the market will fall soon.

Other investing-related posts can be found here.

Hopefully this was helpful to you, have a nice day.

This is not financial or investment advice. Always do your research before risking your hard-earned money