How to go Short

Sometimes, the way you want to go is down.

Origin of shorting and short-selling

What does "(to) short" or "shorting" mean?

"Short" or "shorting" in this context means to bet on the price of an asset to go down. "Short" is the short form (pun intended) of short-selling, originally meaning to sell an asset like a stock, bond, index or currency without owning it. The short seller would first borrow the asset from the holder in exchange for a loan fee, akin to an interest payment. After having the borrowed asset, she would sell it on the open market and get the sell price in return. If the price of the asset drops in value, the short-seller can buy the asset back at a lower price and return it to the original holder. the short-seller pockets the difference from the higher sell price and the lower buyback price, minus loan fee for borrowing the asset, plus interest income on the proceeds from the sell until the buyback.

Other than with long investments, initially, the short-seller does not need to pay for the investment upfront. The broker will instead block a certain amount on the account as a safety deposit, called the "margin". The margin requirements for the asset or security determine the potential size of the position. If the position moves against the short-seller, and the margin is exceeded, the broker will issue a "margin call" and request the short-seller to either deposit more funds or reduce the position.

The broker will handle margin calculation and borrowing of shares. It can occasionally happen that the broker will be out of stock to borrow, which means that the short-seller will have to wait or choose a different broker to short. Usually, however, the interest rate for borrowing the asset or security works well as a pricing mechanism to match supply and demand. short-selling without borrowing would the security is called a "naked short" and usually not available to retail investors.

Example of short-selling: Shorting Apple stock

Assume Apple stock ($AAPL) is trading at $180. If a short-seller borrows 100 shares and sells them at the current market price, she would net 100 x $ 180 = $18,000 for the sale. Let's assume that one month later the share price has dropped 10% or $18 to $162, and the short-seller decides to cover the position and buy the shares back at market price: 100 x $162 = $16,200 is the cost to buy the shares back. The bought back shares will be returned to the lender, thereby closing the position. The short seller pockets the difference of the original sale proceeds minus the buyback cost, in this case, $18,000 - $16,200 = $1,800 before fees.

Risks of short-selling

Specifically for stocks, short-selling comes with a much higher risk than buying and holding shares ("going long"). First, stocks can go up by a virtually unlimited amount, while they can only ever go to zero in the down case, e.g., if the company goes out of business. For a short-seller, that means limited profit potential (current stock price minus zero in the best case), and unlimited loss potential if the price shoots up and the short-seller has to cover at much higher prices. Second, as stock prices tend to go up on average, the general odds are not in the short-seller's favor. For example, the S&P 500 has returned an average of approximately 10% from 1926 through 2018. That means that a short-seller who is shorting the S&P 500 and therefore betting on the price of the S&P 500 falling is taking a significant risk as normally you could expect the S&P 500 to go up. In the same 91 years time period from 1926 to 2018, the S&P 500 had only 25 down years, compared with 66 up years. That means there was a 72.5% likelihood of a short-seller to lose money on an annual basis.

Disclaimer: None of the content presented on LongShortGame is investment advice.

Rationales of short-selling

So, given the risks outlined above, why would anyone even attempt to go short in the first place? short-sellers have an essential role in the market. By spotting overvalued securities, they serve a balancing function. While short-sellers initiating new short positions at the beginning may put a bit of pressure on the price of the security to go down, their positions will need to be covered at some point, serving as a pent-up demand to cover. So selling at high price points, and covering at low price points when the price may be depressed serves as a counterbalance.

So, if short-selling is not all bad, what are potential reasons for a short-seller to go short a company, security or asset in general? Here we list seven common reasons to short sell an asset or security:

  1. Expectations of a downturn/recession: In downturns or recessions, generally most asset prices go down.
  2. Shorting as a hedge: An insurance against your long position(s)
  3. General overvalue or bubble: The asset generally doesn't justify the market valuation.
  4. Declining growth: A company with a lot of growth in the past stops growing.
  5. Continuous losses: A company is continuing to make losses.
  6. Expectations of bankruptcy or similar: Expectation of the asset price to go to zero.
  7. Fraud or scam: Doubts of the underlying integrity of the business or asset.

Let's dive into the potential reasons for short-selling. Some mainly apply to stocks, where the share price equals the price of a company's equity. Other points extend to all securities.

Reason 1: Expectations of a downturn/recession

If you expect the economy to cool down and enter a phase of a downturn, recession or even depression, a well-timed short can be an interesting strategy to profit from declining asset prices. This strategy is called a "macro trade" as you're betting on an overall economy change. To execute this strategy, one could typically short individual stocks that would be particularly hit by a recession, or short the entire stock index (such as the Dow Jones, S&P 500 or Nasdaq Composite). Other options would be to short commodities like oil that would be in lower demand if a recession hits.

The difficulty (read: risk) about shorting in expectation of economic downturns is that generally stock prices drop before the recession hits and are thus a leading indicator. Also, stock prices usually rise again before the recession is fully over. Timing the short right is thus very hard, especially since the short-seller is up against the usual annual appreciation of stock indices, for example, the above-cited 10% average return of the S&P 500.

Reason 2: Shorting as a hedge

Shorting as a hedge generally describes the use of short-selling to protect a portfolio against a negative outcome or downturn. The hedge can either be 1:1, meaning shorting the exact asset that the investor is also long, or short-selling highly correlated assets.

Why would an investor choose to hedge instead of outright selling or liquidating the long positions? One example is taxes. The investor doesn't want to sell the long to not incur tax payment, but as protection of the gains creates a short position. Another example would be transaction cost, selling a diversified portfolio of individual stocks and then re-open the positions at a later point could be far more costly than a temporary short in the S&P 500. Or the long position is not liquid, say an investment in a privately held company or an entrepreneur hedging her non-sellable private stock by short-selling publicly traded competitor company stock if an industry downturn is expected. Or an investor plans to sell her home in a year from now and to protect against a real estate price plunge short sells a matching real estate

Reason 3: General overvalue or bubble

The fact that an asset is grossly overvalued is an enticing reason to short it. Throughout history, there is no shortage of bubbles or gross overvaluations. While bubbles are easy to see in hindsight, the deflation of the bubble is incredibly hard to time right. If a security is grossly overvalued, there is no reason for it to not go up another 50% and still be grossly overvalued. On the other hand, the fact that the price of a grossly overvalued asset dropped 20-30% from the peak doesn't mean the bubble period is over, big retractions are common for grossly overvalued assets, and they occasionally return to new highs after a pullback.

Shorting overvalued assets or "bubbles" is generally dangerous and not recommended. The key is to look for a significant turning point or clear indicator that the tides have indeed turned, and still operate with close stop losses. If the bubble starts to deflate, there is usually plenty of time to get on the short train. One number to keep in mind: After some bubbles, asset price can lose up to 95% of its value from the peak. If you only manage to enter the short position 50% below the peak, you can still earn 90% on your short!

Reason 4: Declining growth

For companies and thus stocks/share prices, the "end of growth" for a company can be a particularly good reason for a short position. Many fast-growing public companies get lofty valuations with high EBITDA or revenue multiples, which in some cases can be justified if the companies can turn the growth into massive profits at a later point in time. Amazon ($AMZN), Google ($GOOG) or Facebook ($FB) come to mind.

Once a high growth company stops growing quickly however, markets at some point will re-evaluate the valuation and may stop to assign such a high multiple. There will be two effects impacting valuation models by analysts: One, the revenue growth projections will be revised, and lower revenues in almost all cases have a direct impact on the profit forecast. All things equal, this is already a very negative effect on the valuation. Second, as the company may not be valued as a growth company anymore, but as a "value" company, allowing for much lower valuation multiples.

To give a hypothetical example, a company may have $100M in revenues, growing 50% year over year while incurring substantial losses. Investors may place a high revenue multiple like 6x on the company since, if the company continues to grow at 50% p.a. for five years, the business will generate $750M revenues annually. The 6x revenue multiple would give the company a $600M equity valuation or market cap today, which may be justified given the growth expectations. After all, it could be the next Facebook or Google.

Reason 5: Continuous losses

A company that is continuously losing money and having to raise new funding (equity or debt) may be a great short, esp. when the funding sources run dry. However, loss-making alone is not sufficient to judge a good short opportunity. Many fast-growing companies are initially loss-making as they invest in growth.

Reason 6: Expectations of bankruptcy or similar

In the most extreme form of loss-making, companies may be facing bankruptcy or recapitalizations where the existing shareholders lose most or all of their money. Being short a company that goes bankrupt is a great trade. However, most companies where the market expects a chance of bankruptcy already trade at very low levels, and a successful turnaround could send the share price much higher. Finally, just because a company announced its bankruptcy, the share price will — counterintuitively — not immediately drop to zero. Much to the frustration of short-sellers, as long as there are market participants to pay more than zero for the shares, the price will stay above zero.

Reason 7: Fraud or scam

It sounds perfect: A company is running some kind of fraud, the short-seller goes short, the market finds out, and the price drops to zero. Unfortunately, this process can take years to unfold during which the short-sellers are against a company's management which will do anything they can to push the stock price and explain why it's not a fraud. So while highly profitable in the end, the way there is painful with a lot of shorts blowing up their accounts on the way.

The General meaning of shorting — betting on falling prices

In a more general context and investor talk, the term "shorting" now encompasses not just short-selling as described in the introduction, but any kind of strategy that bets on falling prices and pays off if the price of the asset goes down. As shown in the following section, many of the ways to bet on an asset price going down have nothing to do with selling something "short" that you don't own. The financial system has managed to build an interesting array of instruments, products and services for investors to engage in positions that pay off when asset prices go down.

Three different ways to short or bet on falling prices

Generally, there are three different ways to short assets like stocks, currencies, indices or cryptocurrencies.

  1. short-selling or shorting the "common" (stock)
  2. CFDs (Contract For Difference)
  3. Put options and other option strategies

All four ways to go short have its unique characteristics, profit and loss profile, advantages and disadvantages. Before comparing the strategies and assessing them, let's dive into the details.

1. short-selling or shorting the "common"

Shorting, also just called "shorting", "go short", or "shorting the common (stock)", means to borrow the asset from a holder against a loan fee, and then selling the borrowed asset on the market without owning it. Once the short-seller wants to close the position, she or he buys back the asset at market price and returns the stock to the lender. The difference between the initial selling price and (re-) buying price is the short-sellers profit, minus the loan fee.

In the past, short-selling, for example, a stock would have required to find a holder of this stock to lend it to you and to agree to a stock loan duration until you have to return the shares. But why would any investor lend you shares if they know you want to short sell and bet on falling prices? For an investor, it's quite simple. If, for example, an institutional investor is holding large positions for a long time, they can increase their return by earning the loan fee on top of the asset return. If they don't lend the shares, most likely somebody else will (and earn the fee!), so the short sale will happen in any case. Lastly, while short-selling can induce pressure on the price in the short term, the short-seller will have to buy back the shares again, so a stock sold short is in a way pent up demand. If prices do go lower, short-sellers who have to cover their positions at some point provide some buying support in the future.

In practice, the process of short-selling has been simplified quite a lot. Many (online) brokers nowadays allow their clients to engage in short-selling. For this, brokers have dedicated loan desks who manage shares available for short-sellers, in most cases (semi-) automatically. Brokers are not allowed to lend shares from other clients' portfolios, as these are held on a different book. So before you can short sell a specific stock, you will need to check with your broker if there are enough supply of shares you can borrow. For large companies like Apple ($AAPL) there are almost always shares available for short, but smaller companies may not be as liquid, and there could be no offerings.

For shares, short interest is tracked by stock exchanges and reported publicly. The total number of shorted shares for a company is called the "short interest". Together with the short interest "days to cover" is often reported. Days to cover is calculated as the total short interest divided by the average daily trading volume in shares of the company, resulting in the number of days it would take all short-sellers to cover their positions. Please find below an example for the short interest of Apple ($AAPL):

Apple ($AAPL) short interest and days to cover, screenshot from March 25th, 2019 (Source: Nasdaq)

When going short, you don't have to pay any money upfront. As you are selling assets short, you are instead receiving money, and owe the security. So can you just take the funds, withdraw them, and spend them? That's of course not how it works. First, you don't see the money appear in your brokerage account once you are short any assets such as stocks. Your brokerage account shows the number of stocks you are short as negative, and the cash proceeds are kept by your broker as collateral to make sure you can buy the asset back and return it to the owner. Also, the broker will block a margin amount on your account. This is an additional "insurance amount" for your broker that you are not only able to buy the asset back when the price hasn't changed, but also when it goes up a certain amount. The margin amount required is specified for each asset based on multiple factors, for example, past volatility of the asset you are shorting. The broker makes sure you will always be able to cover your short position because if you are not able to, the broker will be on the hook for the difference against the lender of the asset.

Once you have taken a short position, the asset price may move in your favor (down that is), or against you (up). If the price goes down, everything is good. You start to build unrealized gains, your available margin goes up as the unrealized profits serve as an additional cushion. And finally, the required margin for the same position that you entered is going down. The last part may be unintuitive at first, but it requires less capital (= margin) to short 100 shares at $90 than the same 100 shares at $100, assuming all other factors like volatility equal. So to sum up, if the market moves down, unrealized gains pile up and the margin requirement for your position goes down, both effects in your favor. But there is a flip side: If the market is moving up, the same effects work against you. First, your available margin will go down as you incur unrealized losses. Second, as the price of the asset is higher now, it would take more margin to enter the same position you have entered.

2. CFDs (Contract For Difference)

Shorting via CFDs (Contract For Difference) feels very similar to a basic short or "shorting the common (stock)". The differences are more in the background, and about the broker operates. Instead of necessarily borrowing the stock and selling it on the stock market, a CFD broker lets you enter bets between yourself and the broker. So, when you initiate a short position, you win if the price goes down and lose out if the price goes up. The economics work similar to a short. The funds you deposit are your margin allowance, determining how much you can short. If your margin requirements exceed your balance, you risk being margin-called.

So, where is CFD different? The difference is that CFD brokers don't necessarily execute your transactions in the market, but you essentially bet against the CFD broker. The broker usually doesn't hold the position against you but has various options to hedge. When you short 100 Apple (AAPL) shares, the broker can short sell them on the open market, or match you with another customer who is 100 Apple shares long. Typically, CFD brokers have very advanced risk management systems and save some money by only hedging their net positions. For example, they have 1,000 customers trading Apple, 800 are long with 100 shares on average, and 200 are short with 200 shares each. In this case, there would be 80,000 shares held long, and 40,000 shares short. The CFD broker's net position of all customers is 40,000 Apple shares long. So overall the CFD broker only needs to buy 40,000 shares on the market to hedge the entire position of all of their customers, and rebalance as prices positions change.

Instead of charging direct fees to their customers, CFD brokers typically quote all securities and assets as bid and ask prices. At any given point in time, for a certain position size, you can sell and go short at the lower bid price, and buy back (or go long if that is your thing) at the higher ask price. As a concrete example, for $AAPL stock trading at $180, the bid-ask-spread may be $179.80:$180.20. So you could sell and go short at $179.80. If $AAPL then goes down by $1, the new bid-ask-spread would be $178.80-$179.20. If you then close your position by buying back at the ask price of $179.20, you would make $179.80-$179.20 = $0.60. The CFD brokers' fees are inside the bid-ask-spread.

Overall, with CFD brokers you have counterparty risk. If the broker goes out of business or for whatever reason cannot or will not honor your position, you are worse off as if you sold real shares on a stock exchange through a broker. However, for regulated and profitable CFD brokers with a long history, this risk should be small. As a precaution, it may make sense to trade with multiple CFD brokers and don't keep excess funds with brokers in general.

3. Going short with options

In general, there are two types of (plain vanilla) financial options, call options and put options. A call option allows the holder to buy a certain asset (the underlying in option terms) at a fixed price (the strike price) by a specific date (expiry or maturity date). A put option allows its holder to sell the underlying at the strike price by maturity date. This optionality is valuable, and can be used to bet on falling prices and "go short".

The simplest way to go short with options is to buy (go long) put options. Let's go through a concrete example for Apple ($AAPL) stock. If the current stock price is $180, a put option with 6 months expiry left and a strike price of $180 would cost roughly $15.50. The put option gives its holder the right to sell an $AAPL share at $180 in 6 months from now. So, after expiration, the buyer of this option will be making money if the price of $AAPL stock falls below $180 - $15.50 = $164.5 at maturity. In that case, the option holder buys the stock at a market rate below $164.5 and exercise the option to sell the stock back to the party who sold the option for the strike price $180.

There is no need to wait until expiry and exercise the option. In fact, most investors sell their options before expiration. To continue the example above, if after one month $AAPL stock is still worth $180, but there are only five months left, the option price will have dropped to approx. $14.2 as the time to maturity has dropped and assuming all other parameters have stayed constant. If however, the stock price has dropped $10 to $170, the put option is now in the money, it would already be worth something at expiry, in this case, $180 strike price - $170 current stock price = $10. As there is some time left, there is also some time value for the option, so the option's price would be, for example, $18.9. The put buyer is in the green by $18.9 - $15.5 = $3.4 or 22% gain. Note that the current price of $18.9 contains $10 intrinsic value, and $8.9 time value that will melt down until maturity.

Going short by buying put options brings the specific risk of timing. While timing is always important when going short as time is generally not on the side of short-sellers, put options lose significant amounts of money every single day until maturity, and the underlying has to go down faster than the amount implicitly expected when purchased. On the other hand, put options do allow for outsized returns if one manages to time them right.

Other ways to bet on falling prices via options are for example:

  • Buying put spreads
  • Selling call spreads
  • Selling calls

Buying put spreads

Buying put spreads means buying a put with a higher strike price, and selling a put with a lower strike price. Keeping the example from above, you would buy a $180 strike price put option and pay $15.50, while at the same time selling a $170 strike price put for $12.10. Your net cost for the trade would be $15.50-$12.10 = $3.40.

When is a put spread beneficial? Let's say the stock finishes at exactly $170 at maturity, in this case, the $180 strike put pays you $10, and the $170 strike put expires worthlessly. A position that cost you $3.40 to enter pays off $10, a gain of 194%, while buying the $180 put for $15.50 would also pay $10, leading to a loss of $5.50 or 35%. If the $APPL stock goes dramatically lower, however, let's say to $100, you would have gained $80 or 416% buying the single put, while the maximum gains for the put spread are capped at the 194% gain as described above.

Also, when buying put spreads, you net invest funds as the higher strike put will always be more expensive than the lower strike put you sell. This means your position is subject to time decay, meaning if the stock does nothing staying at $180, the value of your two puts in the spread would decay naturally until they are both worth zero.

Selling call spreads

Selling call spreads in effect is the reverse strategy to buying put spreads. You would sell (short) a lower strike price call to collect the option premium (= price), and buy a higher strike price call option with a lower price. To continue the example from above, you would sell a $180 call option and net $17.40. Since a call option gives the buyer the right to buy the underlying asset at a certain strike price, buy selling/shorting the option you give somebody the right to sell the underlying to you for $180. For granting this right, you get compensated with the option premium. To complete the call spread, you then buy the $190 strike call option for $13.70. The net effect is that you get paid $17.40-$13.70 = $3.70.

Your risk/return profile then looks as follows. If the price ends below $180 at the end of the maturity, you can pocket the net difference of $3.70 as both the call option you bought and the one you sold expire worthlessly. If the price ends higher at $190 at maturity, the call option you sold will be worth $10 which you have to fork over to the seller. The option you bought at $190 will expire worthlessly, so your maximum loss from the spread will be $10 - $3.70 = $6.30. A higher price than $190 has no further negative impact as any additional losses on the sold lower strike price call will be compensated by gains on the higher strike price call you bought.

In essence, the higher-strike call you go long reduces the premium to be collected and serves as insurance against (potentially unlimited) losses if the price shoots up. While selling a call spread doesn't provide outsized returns when the underlying moves down significantly, it is a position that gains over time as the time value in the option price decays, even if the underlying doesn't move much.

Selling (naked) calls

Don't ever do this. Seriously. Selling (naked) calls outside of a call spread or without holding the underlying stock is a very risky endeavor and can lead to unlimited losses. Shorting calls is just mentioned for completeness. While nothing on this website is investment advice, really make sure to never do it.