In this article, we’re going to explore **what is shorting a stock** (aka short selling), and we’ll also discuss how it works, and why it’s actually incredibly dangerous. Let’s get into it.

## What is Shorting a Stock?

Firstly, what is shorting (aka short selling)?

Ultimately, **short selling is the reverse of buying / going long in a stock.**

It’s a way of making money when the stock price *decreases.*

It involves selling an asset you do not own and buying it back when the price decreases.

In other words, it’s the process of ‘going long’ / taking a ‘long position’ in a stock (buying it), *in reverse* so that you:

- Sell the stock first, and
- Buy it back later

Put differently, a short position starts by selling a borrowed stock and then repurchasing it at a lower price to ‘pocket’ the difference as the profit.

That is, **the profit from a short position is the difference between the price you sold it for and the price you buy it back for**.

If it still seems counterintuitive and confusing, don’t worry. You’re not alone.

Short selling is one of the most counterintuitive, confusing phenomena of the stock market / financial market. But it does make sense, once you get your head around it.

And it is perhaps one of the most important investment fundamentals of all time, used by everyone from professional hedge funds to savvy retail investors, for the purposes of hedging as well as profiting.

Here’s a video that will help you get your head around the concept:

Okay, now that you know what is shorting a stock intuitively, let’s dig a little deeper into how short selling stock actually works.

**How Does Short Selling (aka Shorting) Work?**

Essentially, it’s a case of the short seller:

- Borrowing the asset from one investor,
- Selling it to another investor,
- Buying it back at a lower market price, and finally
- Returning the borrowed stock to the lender (investor).

Typically, a brokerage firm will handle the borrowing and lending so individual investors won’t usually *explicitly* lend to one another individually.

Let’s consider an example of a short selling strategy.

### Short Selling Example

Imagine you have the following price forecast for Amazon Inc. (AMZN), as of January 2018:

If you look closely, you’ll see that – given this specific forecast – you expect the price of AMZN to **decrease more than you expect it to increase**, over the next 3 months.

In other words, the expected price decrease is greater than the expected price increase.

Put differently, in approximately 3 months’ time, this forecast gives us the expectation that the market price of AMZN will either trade at:

- up to $1,500 (up $200 from $1,300), or
- down to $1,000 (down $300 from $1,300).

In other words, our expectation looks something like this…

Given that we expect the price to decrease *more* relative to our expectation of it increasing, a short sale would make sense.

The short selling strategy would look something like this…

Let’s now consider the happy place where the short selling strategy works out in our favour (i.e., it “goes right”).

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### Shorting a Stock Gone Right.

Such a scenario could look something like this…

We borrow 100 shares from a brokerage firm today at the current market price of $1,300 each, and sell them immediately for $1,300 each ($130,000 in total).

Let’s assume borrowing the shares attracts interest at 3% per year, and investing the $130,000 sale proceeds in a bank deposit earns 2% interest per year. More on that in a bit.

Fast forward to 3 months later, and assume the stock price did indeed fall to $1,000.

We can now buy back 100 shares for $100,000; then return the 100 shares to our lender (plus interest), and take in a total profit of $29,675.

Not bad, indeed.

Here’s the math…

**Sale proceeds – purchase cost – (interest paid – interest received).**

**Sale proceeds**= 100 shares at $1,300 each = $130,000**Purchase cost**= 100 shares at $1,000 each = $100,000**Interest paid**= 3% x $130,000 x (3 / 12) = $975 ## being 3% annual interest paid for 3 months (or 0.75% quarterly).**Interest received**= 2% x $130,000 x (3 / 12) = $650 ## being 2% annual interest received for 3 months (or 0.5% quarterly).

Plug in our numbers to get our profit:

**$130,000 – $100,000 – ($975 – $650) = $29,675**

Here’s our process again (with all the numbers):

Recall that we had 2 expectations – that the price will either be $1,500 or $1,000.

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### Shorting a Stock Gone Wrong.

Now let’s see what our position would’ve looked like if things didn’t go our way – *if the stock price went up* to $1,500.

This scenario would’ve seen us borrowing shares for the same value, $130,000.

That’s because we would still borrow 100 shares at the current market price of $1,300 each, and sell them for the same value ($130,000) today.

3 months later, we’d end up having to buy back 100 shares for a total of $150,000 given a price per share of $1,500.

The interest paid and received would be the same, so we’d end up with a loss and debt equal to $20,325.

Here’s the math:

**Sale proceeds – purchase cost – (interest paid – interest received).**

**Sale proceeds**= 100 shares at $1,300 each = $130,000**Purchase cost**= 100 shares at $1,500 each = $150,000**Interest paid**= 3% x $130,000 x (3 / 12) = $975 ## being 3% annual interest paid for 3 months (or 0.75% quarterly).**Interest received**= 2% x $130,000 x (3 / 12) = $650 ## being 2% annual interest received for 3 months (or 0.5% quarterly).

Plug in our numbers to get our loss:

**$130,000 – $150,000 – ($975 – $650) = – $20,325**

Here’s what our process looks like now:

Now, perhaps you’re thinking – the potential loss of $20,325 is still lesser than the potential gain of $29,675.

Unfortunately, this is not true. And that’s because the “potential” gain or loss is only established by our forecast.

We already know that stock prices and returns can’t really be predicted. Not well, anyway; that’s because stock returns follow a random walk.

Here’s the bottom line…

**Shorting is an incredibly dangerous investment strategy.**

## Why is Shorting Dangerous

When you ‘go long’ (buy) a stock, the maximum you can lose is your investment. And the maximum you can gain is infinity.

That’s because share prices can (theoretically) increase to infinity.

There’s no upper bound / restriction / “maximum” stock price, so the potential for gains by buying stocks is theoretically infinite.

When you short sell a stock, however, the maximum you can gain is the price you sold it for.

That’s because you profit when the price decreases and share prices can only decrease to zero. There’s no such thing as a negative stock price!

Given that share prices can go up to infinity, taking a short position means that the maximum you can lose (theoretically), is infinity.

In other words, shorting can result in infinite losses.

Imagine losing an infinite amount of painful losses. That’s not a pleasant thought.

## Wrapping Up

Alright, so we’ve learned that shorting is a way of making money when the price of an asset decreases.

It involves borrowing & selling a stock at a high price, then buying back and returning stock at a lower price, with the profit being the difference between the sell and buyback price.

The maximum gain from a short sale is equal to the price for which it was sold.

The maximum loss for a short sale is (theoretically) as high as ∞ (i.e., unlimited losses).

With these core 4 points in place, you should never have to wonder what is shorting a stock anymore.

To further your understanding of short selling, we’d recommend reading our article on Leverage & Shorting for more examples on how you can lose more money than you invest in stocks.

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