How To Short Stocks
What Is Short Selling?
In recent years, short selling has been the focus of increased attention and controversy. One of the best-known events on Wall Street this decade was the GameStop short squeeze in early 2021, when a large group of retail investors, communicating primarily via the social media platform Reddit, drove the price of the heavily shorted stock up drastically.1 This resulted in significant losses for some hedge funds with large short positions. The event led to greater scrutiny of short selling practices by regulators and showed how social media-driven collective action among retail investors can disrupt traditional market dynamics.2
Short selling is a strategy where traders profit from a decline in the price of an asset, often a stock. In a short sale, investors borrow shares of a stock they believe will fall in value, sell those shares on the open market, and later buy them back at a lower price to return to the lender. The difference between the sale and buyback price is the profit. However, if the stock price rises, the losses can be substantial, and there is no limit to how high a stock price can go. This makes short selling a high-risk strategy compared with simply buying shares and waiting for their value to rise.
The process begins with investors borrowing the stock from their brokers, which often involves paying interest. After the shares are sold, the investor must eventually repurchase them to close the short position. In this type of trade, time is a key element since the longer a short sale is out, the higher the interest costs and the longer it's been since the trading context gave rise to the trade.
IMPORTANT
Short selling isn't for casual investors. It requires experience and well-thought-out analysis with a strong conviction in your thesis.
Buying a put option
You can also buy a put option to express a directional bias. A long put is similar to short selling a stock. The outlook is for the stock to decline after the put has been purchased and subsequently sell the option back at a higher price. Because of certain account type restrictions you may not be able to short stock, so buying a long put enables you to have a bearish position in a security with reduced capital allocation.
Long puts have defined risk (the original cost of the option is the most you can lose) and undefined profit potential. Puts are typically more expensive than calls because investors are willing to pay a higher premium to protect against downside risk when hedging positions.
Selling a put option can also be an advantageous strategy to purchase a stock, because the credit from the put option reduces the cost basis of the stock position if assigned. Many investors sell puts on stocks they are happy to own and gladly accept payment in return. A short put option can be thought of as a limit order.
For example, you might sell a put at a price you believe is support. Instead of waiting for the share price to fall and trigger your order, you essentially get “paid” to wait for the price to decline below the short put option’s strike price. If the stock price never drops below the strike price, you get to keep the premium.
Think about it: if a stock is trading at $102, and you would buy it at $100, why not sell a put with a $100 strike price? If you receive $5.00 for selling the put, you’ve reduced the position’s cost-basis to $95. You’re already up $500 per contract!
(Note: to sell a “naked” put, or cash-secured put, your account must have enough capital to purchase 100 shares at the contract’s strike price).
Put option spreads
While some of these use cases for put options may sound too good to be true, there are risks associated with selling options. As mentioned before, a short put option has undefined risk. That’s where spreads come in handy.
A spread combines two or more options into a single position to define risk for the seller or reduce cost for the buyer.
A bull put credit spread has the same bullish bias as a single-leg short put, but a long put is purchased below the short option to define the position’s risk. You’ll take in less credit because you have to buy a put option, and the credit received is still your maximum potential profit. But you can rest easy knowing your max loss is defined by the spread width minus the credit received.
For example, if a $5 wide bull put spread sold at $50 collects a $1.00 credit, the maximum profit potential is $100 if the stock price is above the short put at expiration. The max loss is $400 if the stock price is below $45 at expiration because the broker would automatically buy shares at $50 and sell shares at $45. (Remember, short put = buy, long put = sell). The trade’s break-even point is the short put strike minus the premium received.
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