Edge-ucation / Market Commentary

How to Short a Stock

  • Edge Editorial Team

    At Edge Investments, we make investing in small cap stocks enjoyable and edge-ucational. We are here to teach you about investing, keep you up to date on news, and help connect you with companies that you may have a desire to invest in.

    View all posts

Before we get into this, we must clarify something. 

We are not a hedge fund, preying on companies by selling or shorting millions of dollars’ worth of stock. 

We are not institutional investors, looking to influence a company’s valuation by trading enormous share blocks. 

We are simply a group of investing-savvy individuals, looking to shed light on the many complex innerworkings of the public equities market for a new generation of retail investors, or anyone exploring the world of investing. 

“Shorting stocks” is a concept that doesn’t always make sense at first. Usually, the first question asked is: “How exactly can you sell stock that you don’t even own?” 

We all know the basics of benefiting from stocks going up in price, so why can’t we, retail investors, bet on them going down? Shorting is inherently a riskier practice than being long on a company; there are several ways to incorporate bearish betting into your repertoire.  

Let’s investigate this strategy further. 

Table of Contents 

  1. Shorting common shares
  2. Buying put options 
  3. Selling call options 
  4. Selling covered call options 
  5. Squeeze? 
  6. FAQ 

Shorting Common Shares 

The most common (no pun intended) form of betting on a stock going down is shorting common shares. Unlike alternative bearish practices, this involves a single transaction and does not use any derivatives or other financial instruments.

How it works:

To sell short a stock, you’ll first need to set a price in which you would like to sell, or “short”. Even if you are bearish on a company, you should aim to short at the highest price you can, just as you would look for a buy as low as you can if you were long on (aka, believed in) a company.

Pretend you already owned the stock. You would want to try and set a sell order as high as you can. Therefore, you may look to set a limit order at a higher price, or simply sell once you’ve noticed the stock has run up a bit.

Once you determine your price, you now instruct your broker to sell short the stock. 

To achieve this, your broker will find shares to borrow, sell them at your price and deposit the cash into your account. Once the cash is in, it is now your responsibility to replace the shares that your firm has borrowed, sub-lent to you, and sold into the open market on your behalf.

As soon as you can, and based on your firm’s regulations, you must buy that same number of shares in the open market to replace them and send them back to the original holder.

The difference in price in which you purchase these shares back, and the price you originally sold the borrowed shares for, makes up your net gain or loss (less commission). In a profitable scenario for you, the stock price would be lower than what you originally sold the borrowed shares for. In a tragic scenario for you, the stock price would be higher than what you originally sold the borrowed shares for. 

Scenario Time 

Let’s say you’ve sold short 50,000 shares of ABC Inc. at $2 per share. $100,000 (excluding commission fees) would be deposited into your brokerage account from the sale of these 50,000 borrowed shares.  

Should ABC’s share price drop to $1 per share, you may now decide this is a good time to buy back the shares that you owe your firm (and subsequently, their client that you borrowed from).  

You proceed to buy these 50,000 shares in the open market for a total of $50,000. You are left with $50,000 in your account after the re-purchase of the shares. 

The shares have been returned, and you are left with a profit of $50,000. However, if this trade didn’t go your way, the scenario may be different. 

Let’s say the share price of ABC Inc. increased to $2.50 per share. You may decide that this is the maximum loss you are willing to take, or your firm’s timer may be up for the amount of time that they can allow you to borrow the shares. You also may have entered a “stop loss” on this trade, which was activated at $2.50 per share. 

You would now have to repurchase the 50,000 shares you borrowed at $2.50 per share, costing you $125,000 (less commission). This would leave you with a -$25,000 loss on your trade. 

This money would come from the margin that your firm required you to put up in order to make this short trade. Either that, or your firm may sell your shares from other holdings in your portfolio to cover the $25,000 you now owe. The initial cash from these borrowed shares comes with a price. Your firm will likely charge a small amount of annual interest, pro-rated monthly. The interest rate can vary, especially with stocks in which the demand to borrow them is high.  

Oh, and if those shares are of a dividend-paying stock, you’ll be covering those distributions as well.

What Can Go Wrong? 

  • Infinite Downside 

The first and most inherent risk of shorting common shares of a stock is that the downside is  unlimited. 

Theoretically, there is no limit to how high a stock’s price can soar. However, a stock cannot go  any lower than zero. When you’re betting on the stock dropping, the price you pay when the  stock price rises has no limit. 

  • Interest 

You also increase the risk by paying interest, and in some cases, dividends on borrowed stock.  These payments are mandatory and are paid in full, never to be seen again, regardless of  the outcome of your trade.  

  • Timing 

Timing is another risk that you should consider before shorting a stock. Your brokerage firm may not let you borrow shares indefinitely and may require you to buy them back before a certain date. In some cases, the brokerage, or the lender of the shares, may not want to hold their positions any longer. This would mean you would have to close  the short trade by buying the shares back, whether you are at a profit or a loss.

Put Options 

If you need further clarity while reading the next two sections that involve options trading, be sure to reference our “What Are Options?” article… This will ensure you’re familiar with options before diving deeper. 

How Put Options Work 

Put options give the contract holder (the put holder) the right to sell a stock’s shares at a specific price. The person on the other side of the put option (the put writer) has the obligation to buy these shares from the put option holder at that same price. 

This price is called the strike price. 

Option contracts are held in blocks of 100 shares. Which means, the smallest option contract you can buy is 1, which gives you the right (or the obligation) to buy or sell 100 shares of the underlying stock. If you buy 2 contracts, this will equate to 200 shares. 

Because an obligation to buy a block of shares is riskier than owning the right to sell at a certain price, the put option holder (you) pays a premium upfront to the put option writer. 

Put options are in-the-money if the underlying stock is below the strike price. They are out-of-the-money if the underlying stock is below the strike price. 

This is because put options go up in value as the price of the underlying stock goes down. 

If you buy a put option on a DEF Inc. with a $8 strike, and the stock is trading at $10, you are currently out-of-the-money, which means you paid a smaller price for the contracts than you would have if you bought them in-the-money. You are out-of-the-money because nobody would pay for the right to sell a stock at a price lower than its market rate. 

That is, unless you’re a bear. 

Because these undesirable put options were not as expensive as the ones already in-the-money, the return you get (should they do what you predict and depreciate in share value), will be hefty in comparison to the premium you paid.

The premium you pay is your maximum risk. You avoid the infinite loss possibility of shorting common shares. Don’t forget, however, options have time limits. They may expire out of the money, worthless, foregoing your entire initial investment. 

The upside is limited to a stock going to zero, and the downside is limited to your premium, which isn’t a bad deal considering it gave you the right to control 100 shares. This is a great example of the coveted asymmetrical bet. 

Scenario Time 

The price of DEF Inc.’s put options (that gives you the right to sell shares at $8/share and expire in 3 weeks) are $0.50 per share. That equates to $50 per contract. 

The contract lets you control 100 shares of DEF Inc., which is $1,000 worth of shares at $10 per share.  

If DEF Inc.’s price dropped to $6 per share, the value of your put options would equate to the intrinsic value, which is the difference between your strike price and the underlying price (which in this case is $2 per share).  

This, combined with the time value, which started at $0.50 per share, also added to the current value of your put options. The time value, however, has been withering away as the expiry date approaches, and is likely trading at around $0.15 per share based on comparable options.

This nets your put options to be worth $2.15 per share, or $215; all from a $50 investment. 

This intrinsic difference is equal to the profit you would make if you exercised your put option instead of a 40% drop in the underlying stock, and has led to a 320% increase in value for your option. Your options position has netted profits at 8 times more than selling the underlying stock would have. Talk about leverage. 

Should you decide to exercise your right to sell DEF shares at $8, you would have the right to. 

Simply sell (or short) 100 shares of DEF Inc. At $8 per share for $800. You can then buy back the stock on the open market at $6 per share for $600, netting the $200 difference (less commission).

What Can Go Wrong? 

  • Principle

You can lose 100% of your initial investment. Options decrease in value as fast as they increase, which is at a multiple of the underlying stock movement.

  • Expiration

Options contracts are opened with an expiry date. The further away the expiry date, the pricier the option is. If your expiry date arrives and the stock hasn’t moved how you want it to, you may expire at a small loss, or even a full loss. 

Selling Call Options 

Selling (also known as writing) options is the reverse approach. Rather than paying a premium upfront for the right to buy/sell a stock at a certain price, you are receiving a premium upfront to take on the obligation to buy/sell a stock at a certain price. 

How It Works 

Receiving a premium upfront is nice, however, the risk of being assigned will require you to fulfill your end of the contract, which can be pricey if you don’t already own the underlying stock. This is called selling a naked call option, which is what we will go over in this section. 

Selling a call option means you are betting on the price of the underlying stock going down. The person on the other end (who is buying the call option) is hoping the price moves upwards. 

Because the call option holder has paid you for the right to buy the stock at the strike price, you must now be ready to fulfill your obligation as the option writer and sell that stock to the option holder at the strike price. 

Your goal is for your thesis to be correct, for the option to never become in-the-money for the option holder, and for it to expire worthless. This way, you get to keep your premium with no obligations. 

However, should the stock move upwards and into the profit for the option holder, you may have to buck up a pretty penny. 

Scenario Time 

You sell covered calls of XYZ Inc. at $20 per share. The stock is currently trading at $16 per share. Someone has bought the right to buy the stock at $20 from you, because they suspect it will rise past $20, making their call option in-the-money.  

If the price doesn’t ever reach $20, you will be happy as you get to keep the premium you were paid, which is the equivalent of the price of the option contracts. No one wants to exercise their right to buy a stock at $20 that is currently trading on the market at $16. 

However, if the stock rises to $22, you may get assigned, as your option holder is now in-the-money by $2 per share, or $200 per contract. 

Once assigned, you will be obliged to sell 100 shares of XYZ Inc. to the option holder for $2,000, representing 100 shares x $20 per share.  

The problem? You don’t own the underlying stock and you will now have to purchase 100 shares of XYZ Inc. on the open market at $22 per share, for a total of $2200, before selling them to the option holder for $2000. This leaves a $200 hole in your pocket, minus the premium you received upfront, which hopefully offsets this.

What Can Go Wrong? 

  • Assignment

If you get assigned to fulfil the obligation of the put contract you sold, you will have to sell the shares of your underlying stock to the option holder. As a naked call option writer, you do not own shares of the underlying stock, which means you will have to buy those shares in the open market before selling them to the option holder at the strike price, for a net loss.

  • Infinite Downside 

Although any net loss incurred through the assignment of a call option is offset by the premium you received, there is still no limit to how high a stock can rise. After selling this contract and before expiry, you are at risk of having to put up a large sum of money, out of pocket, should the stock surge.

Selling Covered Call Options 

What happens if you are bearish on a stock that you already own? Maybe you are worried it could pull back a little bit, but still don’t want to sell as you have hopes it will rise despite the possible risk. Or perhaps you are bullish on your stock, but bearish on the market conditions. 

This is where selling out-of-the-money covered call options come in.  

How It Works 

Covered call options carry inherently less downside than a naked call option. The fact of the matter being: you own the stock. 

Selling these at a strike price higher than the market price is a wonderful way to insure yourself against any possible bearish movements of the stock you are holding, as well as to mitigate any temporary bearish sentiments you may have about the stock, despite the fact that you may be bullish on it, long term. 

Selling covered calls provides you with a premium upfront. This premium can be continuously collected, as long as the stock doesn’t rise up to the strike price. Consider it a manufactured dividend. If the stock ends up rising past the strike price you have sold the covered call for, you are now simply forced to sell your stock at a price higher than you bought it for in the first place.

However, if the stock stays flat or even falls a little in value, you are constantly collecting premiums, which is cash you get to keep, offsetting these reductions in value. They can even be used to buy more stock at a better price! 

Scenario Time

You have been holding ABC Inc. for quite some time now. Originally buying the stock for $20 per share, it is now trading healthily at $40 per share. Although you feel good about this company, you want to protect yourself from any bears that could possibly get in your way.

You decide to sell covered calls at $50 per share. This means that should the stock not exceed $50, the call option holders will not assign you, leaving you with a premium in your pocket.

Should ABC Inc. drop to $30 a share, you still will not get assigned. You can simply sell more covered calls for premiums. These premiums, if done properly, can help add cash to your portfolio and offset any reduction in share price. Not only that, but this also gives you cash to purchase more of ABC Inc. at a lower price.

What if the price of ABC Inc. appreciates past $50 and you get assigned?

We’re sure you aren’t mad about selling a stock at $50 that you bought at $20. You can even jump right back into the stock afterward, if desired.

What Can Go Wrong? 

The risks when selling out-of-the-money covered calls on a stock that you own that has already appreciated significantly, is one of opportunity cost. In the event that you sell covered call options, and the share price rises dramatically, you’ll miss out on this share price gain. 

If you are truly long on your position and end up losing it to an assignment, you may be disappointed to have to buy the stock back at a higher price. 

Otherwise, this is a safe way to take a minimal risk, modest reward bet on a stock that you own and are feeling a bit bearish on in the short-term.

Squeeze? 

You may have heard this term more frequently since the first few months of 2021. Ever since the legendary rally of newly-dubbed “memeification” of stocks such as GameStop and AMC Entertainment Holdings, traders across the globe have been seeking “short squeeze” targets like there’s no tomorrow. 

A short squeeze occurs when there is very large short interest in a stock. This means millions of shares are all being sold short, which makes it difficult for the price to get past this resistance level. All these short sellers are looking to make buy orders at a lower price, in order to make a profit. 

At the same time, these short sellers are typically professional institutional traders, managing large amounts of money, therefore they will have stop losses in place. In the world of shorting, these exist as buy orders slightly above where they shorted. Buying back shares at a 15% loss is better than the infinite risk of letting the stock fly past your short selling price! 

So now picture this. 

There is a ton of short interest on a stock. There are many stop losses in the form of buy orders above the price of the short positions. 

Enter a massive rally of buying. Whether from retail, or an opposing institution, large influxes of buying volume are what cause a stock’s price to move higher.  

So now, as this tsunami of buyers are gathering up the stock at whatever price is available, not only can this send the share price higher than where the short sellers shorted it at, it will also trigger all of the “stop losses” that the short sellers used to protect their positions. 

As we’ve learned, these stop losses are all buy orders, so when they get triggered, it adds even more fuel to the fire via excess buying volume. This tends to send a stock price “to the moon” so to say, as the short sellers all get squeezed out of their trades. 

Let’s play this out in a simplified scenario similar to the meme stock phenomenon that occurred earlier this year. 

Scenario Time 

Hedge Fund AAA has sold short 5 million shares of ABC Inc. at $10/share. This represents a $50 million cash injection into their account, that they’re hoping to buy back at a lower price. 

They hope to buy back the stock around $5, which would net them a $25 million gain (less commission). However, as insurance against their thesis being incorrect, they have a stop loss in the form of a buy order at $12/share. 

This means that in a worst-case scenario, they buy back the stock at $12 and limit their loss to $2/share, or $10 million. 

As this is happening, there are millions of retail investors plotting away on chat rooms, recognizing ABC Inc.’s massive short interest, and realizing if they deploy enough buying power, they can squeeze Hedge Fund AAA out of their position.

100,000 of the retail investors are pledging a total of $100 each to buy into ABC Inc., regardless of the price. This brings in 10 million shares, or $100 million of buying power. As these investors buy the stock up, the huge amount of buying volume pushes the stock past $10.  

As the stock pushes up to $12, something happens. 5 million shares from Hedge Fund AAA’s position get triggered. This automatically adds $60 million of buying power into the stock, propelling it to surge even further upwards.  

This is a short squeeze. The short sellers get squeezed out of their short positions by having their stop losses triggered, and the retail crowd wins.

Frequently Asked Questions

Q. How can I put in a short order?

     A. Not all broker apps accommodate shorting. Stock brokerages can execute short orders; however, they often require a certain amount of margin to be put up in case the order doesn’t go your way. That way they are not chasing you down for funds.

Q. What is a stop loss?

     A. A stop loss is a limit order (an order set to execute at a specific price only) that is set at a price that minimizes your losses. On a standard trade, you may put a limit sell order 10% below your entry price to limit your loss to 10%. On a short order, you would place a limit buy order 10% above the entry price that you sold short a stock at, which would achieve the same result: limiting your loss to 10%. 

Q. What is the difference between trading options contracts and exercising them?

     A. The way options are priced makes it so that there isn’t much of a difference between exercising the option or buying/selling. However, exercising or assigning options can take time to be processed, and unless you are looking to own shares of the underlying stock long term, it may be quicker to sell the contract.  

  • Edge Editorial Team

    At Edge Investments, we make investing in small cap stocks enjoyable and edge-ucational. We are here to teach you about investing, keep you up to date on news, and help connect you with companies that you may have a desire to invest in.

    View all posts

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