How Does Short Trading Stocks Work? - Beginner’s Guide

20 October 2023

A short stock trading strategy is one of the most used strategies among experienced stock traders. Going short means that the trader doesn’t directly own the stock. Instead, he/she borrows it from an investor, with the hope that the asset’s price will fall. Once the price of that stock drops, he/she buys it back and gives it back to the lender. The trader gains from the difference between prices when he/she sold it and when he/she bought it back.

How does short stock trading work you ask? The trader opens a position when he/she borrows an asset from the investor. Then he/she starts to sell the borrowed asset at the market price and bets that the asset price will decline in the marketplace and he/she will be able to purchase it cheaper.

Short trading stocks are primarily associated with a bearish market. The market is bearish when it experiences an extended decrease in prices. This happens when investors have negative sentiments and pessimism or something that happens to the overall economy.

Traders usually short stocks when they believe that a massive drop in the price is coming. Because of that, there are some types of stocks that are frequently short-traded. For example, seasonal stocks whose prices fluctuate depending on what time of the year it is. For example, companies that produce bathing suits.

Even though some traders gain from shorting stocks, it’s just as easy to lose money as well. In fact, shorting stocks can sometimes lead to unlimited losses, which is why it’s reserved for experienced traders.

What Does Short Trading Stocks Mean?

Short trading stocks as already mentioned mean that the trader borrows an asset from an investor. How is that? The broker “owns” a big number of shares and stocks, but these stocks and shares actually belong to its clients - “the investors”. So every time you are borrowing an asset you are borrowing it from an individual investor. To make short trading stocks a bit more simple let’s take an example.

Imagine you hear that Apple had a very serious issue with its production on the next iPhone. You are 100% sure that the price will drop in the coming days as Apple shares more information about the incident. In any other scenario, this would be an immediate “sell order” from your side if you owned any of the stocks. However, in this case, you don’t own any Apple shares, but still want to make some money out of this incident.

Let’s say you borrow 10 shares from a fellow investor. The price per share is $100, so the total amount you gain from selling is $1000. For shorting stocks you need to wait a few days for the price to drop after the incident. Let’s say that the price dropped to $90. You then buy these stocks back and give them back to the lender. Without any fees, your payout is $100, but after paying fees, paying the lender and all overheads your payout is more likely to be around $70-80. This may seem pretty low, but you’ve pretty much gained 7-8% of your initial investment in a few days, which is quite substantial in today’s market.

When Should You Short-Sell Stocks?

Short selling is linked to a high-risk ratio and when the trader is shorting stocks he/she needs to be assured that the price of an asset isn’t going to increase. Stock short selling is not a viable strategy when the market is growing. However, it’s an amazing one when a crisis or some kind of market correction is expected. It doesn’t have to be an all-encompassing stock market crash similar to the 2008 crash or anything like that. But maybe some kind of correction in a particular industry.

Some traders have mentioned that short-selling is amazing during elections as well. If it’s looking like a landslide victory for one of the candidates, you can short-sell the company stocks you think will be negatively affected by his/her policies. These world events truly show the best stocks for short trading which then subsequently become a part of your strategy.

According to historic data in the US, a president’s third year is the strongest for the stock market while the fourth is the weakest and is characterized by the lowest returns and incomes. This means that traders who want to short stocks can buy these stocks somewhere at the end of the third year, and observe the market during the last year. It’s best to do this strategy if it’s the president’s second term, so you know for sure that his/her policies will be changed after the elections.

What Are the Best Stocks for Short Trading?

There is no specific company whose stocks are perfect for short-trading. If someone says that the company has the best short-trading stocks, this means that this company is a goner and soon is going to go bankrupt. If that’s the situation, then nobody wants to lend out their shares, they simply want to sell them and get out as fast as possible. In order for short trading to work, there needs to be somebody willing to lend the shares out and then buy them back. If the company is on the verge of bankruptcy this means there won’t be an investor who wants to invest his/her funds in the company.

But, not everything is doom and gloom. There are some companies that have seasonal growth, meaning they remain relatively flat for a few months, then grow rapidly during a specific quarter, and then just go back to normal. For example, you know that a company releases something new every year or every quarter. You know that the stock price leading up to it will grow due to anticipation. Depending on the success of the newly released product, it may be a good time to start short-trading. For example, if the release is successful, then it’s best to steer clear. But if it’s not going according to plan, then punching on the opportunity is recommended.

For example, remember the Samsung Galaxy Note 7 fiasco, when the phones would ignite seemingly out of the blue. Samsung was forced to recall all of the phones, returning money to customers and costing it dearly. This rocked the stock price to its core. These kinds of scenarios are like a pot of gold for most short traders.

Why Shorting Stocks Isn’t For You

Short trading is extremely risky. Why? Because you are pretty much in danger of having limitless losses. To make it more simple, let’s go back to the Apple stock example.

As already mentioned in the previous example you bought 10 shares at a price of $100 each. But it turned out that the Incident was actually just a small glitch and nothing serious. In fact, Apple fixes it in a day and continues the product updates. Instead of the price per share dropping to $90, it rises to $120. You still have to return these stocks, and waiting for the price to drop is going to cost you quite a lot paying the lender interest. So you buy the stocks at $120, costing you $1200 in total, and you now have to return it to the lender, bringing your losses to $200.
Had you not sold them at $120 a share, they could have risen even further, thus costing you more and more.

Short trading stocks are quite risky for beginner and inexperienced traders. Even for experienced traders sometimes short trading can be loss-heavy. And If you don’t buy the stocks back before the price grows too much, you’re potentially exposing yourself to unlimited losses of money you may not even have (therefore going into debt).

Short Trading Stocks - Key Takeaways

Short trading stocks means borrowing shares from an investor. Selling them for a high price. Expecting the price to drop. Buying them and giving them back to the lender. The price difference between the first sell and first buy-back is the payout that a short trader gets.

A lot of people short sell stocks when they think a massive drop in the price is coming. Not all stocks are good for this kind of strategy but there are some that fit.

Short selling is not a viable strategy when the market is growing. However, it’s an amazing one when a crisis or some kind of market correction is expected. For example, according to some traders, the election period is one of the best times for short stock trading.

Short trading is extremely risky which is why this strategy is mostly used by experienced traders. The risks mostly revolve around losses, which could potentially be unlimited if not careful.

FAQ on Shorting Stocks

What is shorting a stock called?

Shorting a stock is called “shorting” or “short selling”. Shorting is primarily associated with a bearish market. Traders simply borrow stocks from investors and sell them, expecting a drop in price. Once the price drops, they buy these shares back and return them to the lenders. The difference between prices when the investor sold and bought the shares is the gain they receive.

What are the best stocks to short sell?

There are no individual company stocks that are the best stocks to short sell. However, there are specific industries where the strategy could be useful. These companies tend to have quarterly or seasonal changes to their share prices, which then fluctuates the price.

Traders who are well aware of these changes can then take advantage of this pattern and use it to their advantage when shorting. For example, if you’re sure that a company’s reports are showing a negative outlook, then you can go ahead and start shorting.

Is short-trading stock trading profitable?

Short trading can be one of the most profitable trading strategies today. As long as you approach it in a smart way with minimal risks, you may not even need any initial investment, to begin with.

You borrow the stocks, not buy them, so there is usually no up-front payment, it’s only the interest you have to pay down the line. If your trade is successful very quickly, then you can even generate a payout without having to pay the fee.

Basically, you can turn $0 into $100 if the market provides such an opportunity. But the risks are colossal as well. Anything you lose on this market comes directly out of your pocket. If it’s too much, it could land you into debt.