Shorting a Stock

Most investors buy a stock hoping that its value will rise so they can sell it in the future for a hefty profit. But you also can take a reverse position—betting against, or “shorting,” a stock so you benefit if its share price falls.

Reasons to short a stock:  You think a particular company suffers from problems that are likely to drag down its share price. Those reasons could include fundamental deterioration in the business, deceptive accounting or a negative future outlook due to shifts in its industry or new competition. Shorting a stock also can offer protection for the rest of your portfolio. Example: You short-sell stocks that you think are troubled or vulnerable to a market pullback. Then, if the market does decline, you may be able to offset losses or even make profits on your short positions.

Shorting can be highly speculative but also enormously profitable. Legendary hedge fund manager John Paulson made one of the most lucrative short trades in US history back in 2007, when he realized the US housing market was in a bubble and was about to get hit with a wave of mortgage defaults. Paulson shorted a slew of Wall Street banks, mortgage lenders and credit-rating agencies, all of whose stock prices collapsed, producing $15 billion in profits for Paulson that year.

Bottom Line Personal spoke to short-trading expert Brad Lamensdorf to find out the savviest ways to bet against stocks…

How to Short a Stock

Most large brokerage firms like Schwab and Fidelity allow individual investors to short stocks, but the process is more complicated than traditional stock investing. To short a stock: You typically borrow shares of the troubled stock from your broker, then immediately sell them on the open market and collect the proceeds from the sale. When the stock price falls, you buy back the shares at a lower price and return them to your broker…and pocket the difference as profit. Steps to take…

Apply for a margin account at your brokerage firm

This is a special type of account that allows you to short securities. Your brokerage firm often will lend you some shares of the stock and sell it on your behalf. To make a trade, you’ll need to keep cash in your margin account equivalent to at least 50% of the short stocks’ value, according to Federal regulations. This serves as collateral for the loan obligation to repay the borrowed shares.

Place your short-sale order

Specify the number of shares you want to borrow and then sell on the open market.

Maintain your short position for as long as you need

But keep in mind that you have to pay interest on your borrowed shares, typically an annual percentage rate (APR) ranging from 8% to 13% depending upon the brokerage firm and the stock you decide to borrow.

Monitor the stock price closely

If the stock price rises: It will cost you more to buy back the shares and you’ll have to find that extra money from somewhere else and suffer a loss on your short position. If the stock price falls: You can buy it back for less than you had sold the borrowed shares for, allowing you to return the shares to the brokerage while taking a profit. The profit would be (not counting fees or interest) the difference between the price at which you sold the shares minus the price you paid to buy them back.

What to Keep in Mind When Shorting a Stock

You can short more than stocks

Investors also can bet against equity exchange-traded funds (ETFs), which trade like stocks on major exchanges. This is useful if you are bearish on the fundamentals of an entire niche in the stock market. Example: Earlier this year, I shorted the Van Eck Oil Services ETF, which invests in about 25 companies that provide services to the oil-equipment and oil-drilling industries. Reason: A worldwide oversupply of oil and secondary impacts from tariffs were likely to keep energy prices low, deter drilling activity and suppress demand for oil services.

Don’t short a stock just because valuations look expensive

A stock’s price can keep rising irrationally and grow even more overvalued for a longer period than you can stay solvent. What to look for when identifying stocks to short: Fundamental deterioration in the business, such as slowing growth in earnings per share…slowdowns in the company’s industry…changes in government policy and regulations…poor management decisions…deceptive accounting, such as overstating revenue growth when it is clearly not sustainable.

Three stocks I have shorted this year…

AutoNation (AN)

One of the largest automotive dealers in the US with more than 240 dealerships. The automotive sector is facing potential headwinds from new tariffs and broader consumer uncertainty.

Bank OZK (OZK)

A fast-growing community bank with $38 billion in assets operating in nine states from Florida to Texas. The bank has a very high concentration in commercial real estate construction loans. If the commercial market weakens, Bank OZK’s loan portfolio could experience significant losses.

Credit Acceptance Corp. (CACC)

A consumer finance company that specializes in sub-prime automobile loans to borrowers with low credit scores. Revenue is expected to remain flat over the next several years as the company comes off a pandemic-driven boost in car sales. If the economy slows or stalls, CACC’s business could face increased defaults and lower loan originations, further pressuring earnings.

Shorting a stock is much riskier than simply investing in a stock

When you buy a stock, your downside is limited to 100% of the money you invested. Example: If you invest $20,000 and the company goes bankrupt, you lose $20,000. But if you short a stock, its share price could keep rising indefinitely. That means there is no upper limit to the amount you are obligated to shell out to buy back the stock and repay the loan.

Other shorting dangers…

Margin calls

If you short a stock and its price rises, your brokerage firm may require you to maintain enough cash in your margin account to offset potential losses. Otherwise, you’ll get a margin call, requiring you to deposit additional cash to bring your account up to the required level.

Short squeezes

When a heavily shorted stock unexpectedly rises in value, it can trigger a cascade of further price increases as more short-sellers panic and stampede to buy the stock so they can quickly close out their losing positions. Each wave of purchases causes the stock’s price to surge higher, punishing anyone still holding onto a short position. One of the most famous short squeezes occurred in 2021 with videogame retailer GameStop. Investors on the social-media website Reddit pushed up the stock’s price more than 1,600% in a two-week period.