What Is Short Selling Stock? How It Works and the Risk

What is short selling stock, and can it make you money? I got that question all the time when I was a licensed broker, and I still get it in the comments on the channel. Most people only know one way to make money in the market. Buy low, sell high. Short selling flips that around. You sell high first, then you try to buy back low. In this article I am going to explain how it works in plain English, share a couple of my own shorts from over the years, and tell you where I think most people get hurt.

Where does the money go when a stock drops?

Here is a thought I used to put in front of my students. You wake up one morning, check your phone, and your stock fell through the floor overnight. You have that sick feeling in your stomach. And the first thing you say is, if only I had sold yesterday.

So where did your money go? It did not go to the brokerage. It did not disappear into cyberspace. Somebody on the other side of the market was set up to profit from that drop. In many cases, that somebody was a short seller. While you were watching your shares fall, they were watching their position rise. That is the part of the market most beginners never see, and it is exactly why I want you to understand it.

How short selling actually works

Think of it like a loan. When you want to buy a house, the bank asks for collateral. In the brokerage world, that collateral lives in a margin account. You can use cash or the stocks you already own as your collateral. That is step one. No margin account, no shorting.

Step two is the borrow. You tell your broker you want to short a stock. The broker borrows those shares, usually from another customer or from its own inventory, and sells them into the market on your behalf. Now you have cash in your account from that sale, and you owe the broker the shares.

Step three is the wait. You want the stock to go down. If you sold the borrowed shares at $20 and the stock drops to $12, you can buy them back at $12, hand them back to the broker, and keep the $8 a share difference. That is called covering your short.

Step four is the part people forget. Borrowing is not free. The broker charges interest on the borrowed shares, and on a stock that is hard to borrow that fee can get expensive. And if the company pays a dividend while you are short, you owe that dividend to the person you borrowed from. So the clock is working against you the whole time you are in the trade.

My Seadrill short

Let me give you a real one. Years ago I shorted Seadrill Limited, ticker SDRL, when it was trading at $3.93. Seadrill was an offshore oil driller carrying a mountain of debt. In my professional opinion, way too much debt for the price of oil at the time. I did not have a crystal ball. I just looked at the balance sheet and asked a simple question. How does this company pay its bills if oil stays low? I could not find a good answer, so I shorted it.

I wrote at the time that only time would tell if I was right. Well, time told. The old Seadrill shares ended up going to zero. If you followed that trade, you made serious money. But I want to be clear about why it worked. It was not a hunch. It was debt, cash flow and a commodity price that did not cooperate. That is the kind of setup I look for on the short side. A story that is broken, not just a stock that has gone up a lot.

The General Motors lesson from 2008

Here is another one from my own life. Back in 2008 a group of people at the company I worked for pooled their money and bought a big pile of General Motors stock. They thought they were buying an American icon on sale. My partners and I looked at the same company and saw something different. We saw a business bleeding cash in the middle of a financial crisis, and we did not believe it could survive in its current form.

So while they were celebrating their purchase, we went the other way and shorted it. You know how that ended. The old GM went into bankruptcy in 2009 and the original shareholders were wiped out. I do not tell that story to gloat. I tell it because both groups looked at the same stock on the same day and came to opposite conclusions. The difference was that one group bought a name they recognized, and the other group read the financials.

The risk that makes shorting different

Now for the part I need you to hear, because this is where people get destroyed. When you buy a stock for $20, the worst thing that can happen is it goes to zero and you lose $20 a share. Painful, but the loss has a floor. When you short a stock at $20, there is no ceiling. It can go to $40, or $80, or $200, and every dollar it rises is a dollar you owe. Your loss is unlimited on paper.

Your broker knows this, which is why they watch your margin account like a hawk. If the stock rises far enough, you get a margin call. That means put up more collateral right now or the broker will buy back the shares for you, at whatever the price is, and you eat the loss. You do not get to pick the timing. That is a horrible spot to be in.

What a short squeeze is

You have probably heard me use the phrase short squeeze on the channel, especially when I talk about crypto. Here is what it means. Imagine a stock where a huge number of traders are short. Then some good news hits and the stock jumps. All of those shorts are now losing money at the same time, and the only way for them to stop the bleeding is to buy shares back.

But buying pushes the price up. So the first shorts to cover push the price higher, which forces the next group to cover, which pushes it higher still. It feeds on itself. That is a short squeeze, and it is the reason a beaten down stock can double in a day with no real change in the business. If you are on the wrong side of one, it is brutal. If you are long and you spot one coming, it can be a gift.

My rules for anyone thinking about shorting

First, know why the stock should go down. Too much debt, shrinking sales, a product nobody wants, an accounting problem. Something real. A stock being expensive is not a reason by itself. Expensive stocks can stay expensive for years, and the market can stay irrational a lot longer than you can stay solvent.

Second, use a stop loss every single time. Decide before you enter the trade what price proves you wrong, and get out there. No hoping, no averaging into a losing short. With unlimited downside, hope is not a strategy.

Third, keep it small. A short should never be a position that can take down your account. I treat shorts as a tool I use once in a while, not a way of life. Most of my wealth has been built by owning good companies for a long time, and I want yours to be built that way too.

I used to tell my students that selling short is like trading away an All Pro linebacker right at the edge of his prime. Everyone thinks you are crazy the day you do it. Then he pulls up lame the next season in a different uniform, and suddenly you look like a genius. The trick is that you have to be right about the decline, and you have to be able to survive being early.

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Sources

• FINRA investor education on margin accounts and short selling
• SEC Investor Bulletin on short sales and Regulation SHO
• My own trading notes on Seadrill Limited and General Motors

I am not a financial advisor and nothing in this article is financial advice. Everything here is my own opinion, for educational and entertainment purposes only. Do your own research and talk to a licensed professional before you make any financial decision.