If you've seen the market sell-off of 2022 or were caught up in the meme stock phenomenon of 2021, you might be wondering how you can make money off shares falling.
You can do this by going short or shorting a stock.
Short selling historically gets a bad rap in the investment world because traders are benefiting from a company's loss. And if enough traders or fund managers short a stock, it sends a message to the market that can result in more selling and lower prices.
However, not everybody believes short selling is bad.
One argument is that it keeps the market running efficiently because short sellers dig out companies that are "overvalued".
The strategy can also be used to offset losses during a stock market crash. This can be particularly useful for investors holding a portfolio of dividend shares that they'd prefer not to sell as prices fall.
While it varies from country to country, there are a few different ways to short sell stocks. In Australia, if you want to traditionally short sell stocks, you'll need to find a wholesale provider or be a "sophisticated investor" (earn $250,000 or have $2.5 million in net assets). But there are a few other ways to short a stock for retail investors, including borrowing shares from a broker and trading put options and CFDs. We'll give you an overview of what short selling means, how you can do it and the risks involved.
Important: Short selling is a controversial strategy and not everyone thinks it should be allowed. Some countries have banned it entirely. It is also a riskier strategy that relies on market movements over a short period and at times is not based on fundamentals. Either way you look at it, short selling is for experienced traders only.
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What is short selling?
The idea behind this investment strategy is that if you think a stock's value is going to decrease, you can make money out of it.
If you've entered a trade, you are either "long" or "short".
A short position refers to someone that looks to profit while the price of an asset is falling, while a long position seeks to profit on assets that are rising.
If you enter a short position or short sell, you borrow the stock from a broker, sell it at the market price and then buy it back when the price has decreased. You then give the stock back to its legitimate owner and keep the profit.
The plan is to sell the stock when the price is higher and "buy" it back when the price is lower, profiting the difference.
A quick example: Say you think CSL's stock price is going to fall today. You borrow 10 CSL shares that cost $300 each and sell them at the market price ($300 x 10 = $3,000). It turns out that you're right, and by the end of the day, they're worth $280 each. So you buy them back for less than you sold them ($280 x 10 = $2,800) and then give them back to the broker. You keep the profit, which is $3,000 - $2,800 = $200. Even after the fee that you'll have to pay to the broker for the stocks you borrowed, it's a nice earning.
It sounds easy, but the problem is that things could also go the other way around. If it turns out that you were wrong, and at the end of the day, 1 CSL share is worth $310 instead ($310 x 10 = $3,100), you'll lose money ($3,000 - $3,100 = -$100).
Why would anyone short a share?
The entire purpose of shorting a share is because you believe the company or the market as a whole is overvalued.
This could be for a number of reasons, including a shrinking sector, the business has been overhyped or there is simply a prolonged run-up on a company's share price.
You might also be shorting a stock because you think the market as a whole is overvalued. If the market has had a prolonged bull run and the market appears to be heading towards a recession, it could be a sign that share prices are likely to fall.
Finally, you might simply think sentiment is weak. After all, you are only trading over a short period so if other investors think a particular business might fall, you can trade off this news.
Finder survey: How much money do Australians have invested in ETFs?
Response
5000
11.24%
1000
10.65%
10000
8.88%
20000
7.69%
50000
4.73%
25000
4.14%
2000
3.55%
1
2.37%
30000
2.37%
4000
2.37%
100000
1.78%
40000
1.78%
65
1.78%
8000
1.78%
11000
1.18%
110000
1.18%
12000
1.18%
15000
1.18%
150000
1.18%
200
1.18%
3000
1.18%
35000
1.18%
400
1.18%
6000
1.18%
75
1.18%
7500
1.18%
10
0.59%
100
0.59%
110
0.59%
120
0.59%
130000
0.59%
14
0.59%
1500
0.59%
160000
0.59%
178000
0.59%
18000
0.59%
2
0.59%
20
0.59%
200000
0.59%
250
0.59%
250000
0.59%
26000
0.59%
29000
0.59%
300
0.59%
40
0.59%
50
0.59%
500
0.59%
567
0.59%
6500
0.59%
65000
0.59%
678
0.59%
69000
0.59%
7000
0.59%
70000
0.59%
750
0.59%
75000
0.59%
760
0.59%
800
0.59%
82000
0.59%
8500
0.59%
95000
0.59%
Source: Finder survey by Pure Profile of 1145 Australians, December 2023
Why would you loan out shares to be shorted?
In order for short sellers to exist, there needs to be someone willing to loan the shares out.
As such, you might be thinking why would they want short sellers to bet against businesses that they own? It's because they get money to loan out the shares.
Let's go again with our CSL example, but this time let's say you're bullish on CSL and want to hold the company for a decade. If you like the company and want to earn some additional income off the shares, you can lend them to short sellers. These short sellers would have to pay you for the right to bet against them. Now your own paper wealth would change if the price of the shares fell. But if you have no intention of selling, it doesn't materially change your circumstances.
Secondly, the shorters aren't necessarily correct. They simply have a different take on a business's fundamentals than you do at a particular time. So if you think the company is undervalued even as shorters say it's overvalued, then you can effectively cash in on them disagreeing with your opinion. Better still, even if a company is on the high end of your valuation, that doesn't necessarily mean the share price will fall.
Traditional short selling
The traditional means of shorting a stock directly is to contact a full-service broker or a major investment fund such as Morgan Stanley. Full-service brokers usually offer advice alongside trading and they charge a premium price for the service.
In Australia, the service is usually only available to wholesale investors, professional investors or people investing a minimum of around $500,000.
However, it pays to be aware that since the GFC, the Australian Securities and Investments Commission (ASIC) has clamped down heavily on short selling, so many brokers no longer offer it as a service. Below is the traditional method for shorting a stock:
Find a broker that offers short selling. Not all brokers will facilitate short selling and not all stocks will be available for borrowing, so you may have to do some research.
Open a position to sell it. It will be bought at the market price and held under a contractual lending arrangement.
Keep an eye on the price. Getting distracted is a bad idea. You need to be able to react quickly if things go wrong.
Buy the stock back when you think it's the right moment. You'll need to find a good risk/reward balance. When things are going well, it's easy to become too greedy and wait too long to buy back.
Give the stock back and keep the profit (or sustain the losses). If the price goes down and you buy back for less, you'll have made money out of your short selling. If the price goes up, you'll lose money instead. Don't forget that the risk is all on you.
Many traders prefer to short sell through online share trading platforms. In Australia, there are 2 key ways to do this:
Contracts for difference. CFDs are derivative investment products that allow you to speculate on prices without actually owning the shares. This means that CFD traders can profit whether the prices of stocks, commodities or currencies are going up or down. Be aware that CFDs are complex, risky financial instruments and many investors lose money this way.
Options trading. You can purchase an option on a stock that allows you to sell it at the initial market price within the option's expiry date. If the price goes down, you sell the stock and then buy it back at the new price to make a profit. If the price goes up, you don't sell the stock at all and only lose the value of the option, thus limiting the risk. With traditional short selling, you can buy back whenever you want (unless the owner of the stock claims it back), whereas options normally have a fairly short expiry date.
Risks of short selling a stock
Repeat after us: short selling is for expert investors and you shouldn't do it unless you know what you're doing.
If you look at the stats released by ASIC, most retail investors lose money when they are shorting the market.
The reason it's considered so risky is that you could lose "infinite" money. When you buy a share and "go long", the maximum you can lose is the amount you invested. When you "go short", there are no theoretical limits to how much share prices could go up, and thus to how much you could lose.
It's especially dangerous if a lot of people are short selling shares from the same company and the price unexpectedly goes up. At that point, everyone will start buying back quickly, causing the stock to go up even more. It's what's called a "short squeeze" and it easily becomes a vicious cycle that turns out very expensive for short sellers.
Finally, don't forget that short selling isn't free. Brokers will charge a fee for lending stocks, and there are fees for other short-selling methods too. Be aware that these will partially lower your gains and increase your losses.
Shorting as a hedge
Say you hold a portfolio of stocks and you predict that a market crash is coming or a company's stock is going to fall. To avoid losses to your portfolio, one option would be to sell the stocks of the companies that you hold before their prices drop – if you can get the timing right.
However, if you hold dividend stocks, you might prefer to keep them for the long run for the income. To avoid your portfolio falling in value (without selling the shares), you could short the stocks through a CFD or put options to the amount you think they will fall – and so offset any losses.
Disclaimer: General information only. All forms of investments (and in particular, trading CFDs, commodities and forex) carry significant risk, including the risk of losing more than the invested amounts, market volatility and liquidity risks. Past performance is no guarantee of future results. Such activities are not suitable for most investors.
Trading CFDs and forex on leverage is high-risk and you could lose more than your initial investment. It may not be suitable for every investor. Refer to the provider’s PDS and consider the risks before trading.
Important: The standard brokerage fee displayed is the trade cost for new customers to purchase $1,000 of either Australian or US shares. Where a platform charges different fees for both US and Australian shares we show the lower of the two. Where both CHESS sponsored and custodian shares are offered, we display the cheapest option.
Disclaimer: General information only. All forms of investments (and in particular, trading CFDs, commodities and forex) carry significant risk, including the risk of losing more than the invested amounts, market volatility and liquidity risks. Past performance is no guarantee of future results. Such activities are not suitable for most investors.
Trading CFDs and forex on leverage is high-risk and you could lose more than your initial investment. It may not be suitable for every investor. Refer to the provider’s PDS and consider the risks before trading.
Important information: Powered by Finder.com.au. This information is general in nature and is no substitute for professional advice. It does not take into account your personal situation. This information should not be interpreted as an endorsement of futures, stocks, ETFs, CFDs, options or any specific provider, service or offering. It should not be relied upon as investment advice or construed as providing recommendations of any kind. Futures, stocks, ETFs and options trading involves substantial risk of loss and therefore are not appropriate for most investors. You do not own or have any interest in the underlying asset. Capital is at risk, including the risk of losing more than the amount originally put in, market volatility and liquidity risks. Past performance is no guarantee of future results. Tax on profits may apply. Consider the Product Disclosure Statement and Target Market Determination for the product on the provider's website. Consider your own circumstances, including whether you can afford to take the high risk of losing your money and possess the relevant experience and knowledge. We recommend that you obtain independent advice from a suitably licensed financial advisor before making any trades.
Kylie Purcell is the senior investments editor and analyst at Finder. She has completed a Certificate of Securities and Managed Investments (RG146) and specialises in investment products including online brokers, robo-advisors, stocks and ETFs.
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