What Does Shorting a Stock Mean?

June 5, 2021

Overview: In this article, we'll go over the main points of shorting a stock and what investors do with it.

What Does Shorting a Stock Mean?

Now it's time to talk about some advanced methods of investment that only the masters engage in. Such techniques aren't commonplace and require some experience to perform, but, if done right, they can provide you with a lot more return on your investment than the more traditional techniques. Shorting is one such technique.bu

Though not a word passed around often, Shorting is a high-risk form of trading that, when performed successfully, turns into an effective hedging tool to the market's frequent downturns. Certainly not for the faint of heart, shorting can take as much as it can give. That's why you need to be aware of the risks and mechanics of shorting before doing anything so unpredictable. Below, we'll go over what shorting actually is, why only a few investors do it, and what it's commonly used for:

Definition and Mechanics of Shorting

What if someone told you you can still make money on a stock whose price is plummeting? Seems too good to be true, right? After all, the main point of buying stocks is to sell them later on for profit or cash in on the dividend every now and then. But, despite common logic, certain sophisticated investors have managed to turn what would be a bad situation into a profitable one.

Put simply, shorting is one borrows a stock he or she knows will deflate in value, sell this stock at its original price, and buy back the stock later on when the value is low. The difference between the amount the stock was sold and the amount the stock was bought back for is the profit. On top of that, the stock price could rebound in value after it was purchased back -- essentially increasing the investor's assets even more.

Under this operating principle, shorting can allow an investor to profit off of the decrease in a company's value. This might raise some ethical concerns among those who feel it's just not right, but many economists agree that shorting is an important part of keeping the market liquid and money flowing despite the volatility.

That being said, it goes without saying that shorting is a very dangerous practice. The potential for loss is infinite and the bulk of the success of shorting rides upon your ability to predict the future of a famously unpredictable financial market. It takes a lot of experience and education to pull shorting off correctly. Many who engage in shorting -- for more profits, for hedging, or even just for the fun of gambling -- are quite often glued to the screens of their tv or phone as they try to stay on top of prices.

They look for the common signs that a stock price is about to plummet, like unexplainable extended periods where the stock prices' do nothing but increase. They might also make predictions that a stock price might plummet due to a competitor's release of a better product.

Even then though, the opposite might happen and the prices simply continue to rise. This will evidently be leading you to buy back the stock at a higher price than when you sold it. Many investors as losses big on shorting, just as much as those that made it big. In the end, the risk level only goes to show why only seasoned investors engage in the practice.

Related: Can you Short on Robinhood?

Example Scenarios of Shorting

What is Short Selling?

For you to better grasp the concept of shorting, let us apply the principle to an easy example.

Imagine that there is a company, let's call it ABC Co., and their stock is overvalued at $500 each.

You consider that a company like that cannot be valued at such a high price per stock and so a day will come when those prices will decrease. On top of that, you might have a bit of info on the company's competition and expect to see the companies offering become obsolete quite soon.

You decide to capitalize on this and borrow 10 stocks of ABC Co. and then, sell them at their original price of $500 each.

Your predictions come true and the price of ABC Co.'s stocks depreciates to about $400.

Not wanting to push your luck, you decide this is a good enough price to buy the 10 stocks back. Consider that you sold these stocks for $5000 ($500 x 10 = $5000) and bought them back at $4000 ($400 x 10 = $4000), you made a profit of $1000 ($5000 - $4000 = $1000). Congratulations, you have successfully engaged in shorting.

But with that scenario in mind, consider for a moment what would happen if the prices didn't go down. You sold your 10 borrowed stocks for $500 each then notice that the value of the stocks increases to $550 each. You bide your time and hope to see the value decrease eventually. Suddenly, you see the price of the stocks rise again to $600 each.

At this rate, you might even end up owning the brokerage you borrowed the stocks from. So, you buy the 10 stocks back at $600 each. Since you sold them for $5000 ($500 x 10 = $5000) and bought them back at $6000 ($600 x 10 = $6000), you've incurred a loss of $1000 ($6000 - $5000). Ouch!

What are the Risks?

According to the scenario above, the first and foremost risk of shorting is that you can make a wrong call. If you end up with a wrong prediction, you can sustain a substantial amount of losses. And theoretically, since a stock's price can increase infinitely, your losses could be infinite too. This is why when shorting, you need to back your predictions up with hard evidence and precedents set by history. Without it, you risk stabbing in the dark and losing big time.

Another potential risk is that other investors try to short the same stocks as you do. A large amount of people buying a large number of stocks is generally a good thing for a company. So, in a crab mentality kind of way, you and the other investors trying to short end up ensuring that the prices increase instead of decrease. You and the other investors will end up panic buying your stocks bach -- the activity of which rises the value of the stock even more!

Other risks are basically variations of these scenarios. Many longtime investors who engage in shorting have their fair share of blunder stories. Though potentially lucrative, the fact of the matter is shorting is a high-risk form of investment and should only be done if you are prepared to lose. Otherwise, just trade in stocks the normal way which could still hurt you but far less.

Is it Worth it?

This is a very relative question. Only you, as an investor, can decide for yourself if the gains outweigh the risks. Much can be said about the potential to lose a lot in shorting but the benefits are certainly not something to be overlooked.

Investors use shorting as a means to hedge their long-term investments or mitigate losses. It is a practice that seasoned investors and hedge-funds do as a way to diversify their portfolio and have multiple investments -- any one of which could save the investor from losses when one of the others fails. At the very least, this means shorting is used to create a break-even scenario for investors.

Other than that, shorting is simply another way investors make lemonade out of lemons. The market can act up at times and cause devastation to the finances of many people. It's just the fact of any economic activity: there are inherent risks of failure. Shorting takes that failure and turns it into profit. It rewards those who were able to predict the twists and turns of the market.

So although it is highly advised that you only short what you're prepared to lose, or don't short at all, it helps to know why it exists and why investors do it. This will help you decide for yourself if it's for you.

Bottom Line

Though shorting seems easy enough to understand on its own, it requires more than what most investors are willing to give. The time, attention, and research that goes into pulling it off successfully certainly mean it's not for the everyday person. If you are one of those people who invests in something you can forget about, something that garners you passive income, then shorting is not an activity for you.

It needs dedication and experience. If it were so easy then everyone would be doing it. As stated in the beginning, shorting is a technique best done by the masters in investment and speculation. The battle-hardened investors of legend.

That being said though, if you have some money lying around to spend, and have a love of researching the soap-operatic play that is the financial market, then maybe shorting is something that'll be right up your alley.

About the author 

Jenna Lofton, the founder of StockHitter.com, has been actively trading stocks and investing for nearly 11 years.

She holds an MBA in Finance, and another in Business Administration, and lives in Staten Island, NY.

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