What Is Shorting a Stock [and Why I Don’t Short Stocks]

Watch the full video here: Why I Don’t Short Stocks

Short selling is a fascinating and often debated strategy in the world of stock trading. While it’s a common approach for some traders, it’s not a method I use—and for good reasons. In this article, I’ll explain what shorting a stock means, how it works, and the risks involved.

I’ll also share why I’ve chosen to stick to long positions and why this might be the better path for most beginner traders.

What Is Shorting a Stock?

Short selling is a strategy in which traders profit from declining stock prices. Unlike buying a stock with the hope that its share price will rise, short selling flips the equation. Traders borrow shares from a brokerage and sell them at the current market price, intending to buy them back later at a lower price.

A short seller, of course, would sell shares in the market to take a negative position, benefiting when the stock goes down and buying back those shares (covering that position) at a lower price. This method allows traders to profit during market downturns.

How Shorting Works:

• Borrowing Shares: A trader borrows shares from a leader through their brokerage account.
• Selling High: The borrowed shares are sold at the current price.
• Buying Back at a Lower Price (Covering): If the price of the stock drops, the trader repurchases the shares at the new, lower price and returns them to the lender, pocketing the difference. This is called covering the position.

Whiteboard breakdown of short selling: borrowing shares, selling high, and repurchasing lower to make a profit.

Example:

Imagine you short 100 shares of a stock trading at $50 per share. If the stock’s price drops to $40, you buy back the shares for $40 each, making a profit of $10 per share—or $1,000 in total.

While the concept sounds straightforward, the risks can outweigh the rewards, especially for new traders.

Why Do Traders Short Stocks?

Short selling can be attractive to speculators when they expect a specific stock or market to decline or want to minimize risks.

Here’s why some traders use it:

• Profiting from Declines: This fact is especially advantageous for short sellers if the stock price drops in oversaturated markets. It works best in splendid bear markets or amid volatility.
• Hedging Long Positions: A short position is used in combination with an existing long position, mainly in conditions characterized by a high level of risk.
• Advanced Strategies: The most conventional group of short-sellers is institutional traders, including hedge funds, which employ short-selling and other investment strategies.

Real-Life Example:

The short selling or short squeeze was recently witnessed during the live events in January 2021 involving GameStop Corp. Leverage ratios, and short interest rates were very high in this case, and short parties suffered huge losses when long traders triggered a short squeeze that saw the price of the stock rise sharply.

Risks and Challenges of Short Selling

Short selling might seem enticing, but it comes with unique risks that can be challenging to manage:

Unlimited Loss Potential

In contrast to purchasing a stock in which losses can only equal the value of a stock, short selling can have no limit to a loss. In the case where the stock price goes up rapidly, your losses can easily go up exponentially.

HKD’s meteoric rise from $20 to $2,500 per share demonstrates the massive losses short sellers risk during extreme price movements.

Short Squeeze

A short squeeze is a market phenomenon when one or more stocks that have been heavily short-sold start to go up. Traders who have taken shorts must purchase stocks to make their shorts good. Such buying pressure can also drag the stock further up because of the resulting losses.

Margin Requirements

Short selling involves using a margin account with additional mandatory assets to provide cash and securities to cover losses. This means that if you fail to meet margin requirements, you will receive a margin call, which will require you to deposit more money or exit your position.

Borrowing Costs

Borrowing shares isn’t free. Brokerage firms charge for facilitating the borrowing of shares, and some shares have expensive rates due to their scarcity.

Why I Don’t Short Stocks

Personal Experience

When I first started trading in the market in 2001, I was solely focused on buying stocks. The idea of short selling never crossed my mind. As I gained experience, my mindset became hardwired to look for long opportunities. Even after learning about shorting, it didn’t feel intuitive for me, and I chose to focus on what worked—long positions.

Challenges of Switching Biases 

Flipping between long and short positions is like trying to play tennis with both hands—it’s complicated. Most traders develop a bias, and frequent switching can lead to mistakes. By the time I recognize a good short opportunity, the best entries are often already gone.

Why Beginners Should Stick to Long Positions

Short selling comes with complexities that can overwhelm new traders. Here’s why focusing on long positions is often a better choice:

Simplicity 

Buying low and selling high is a straightforward concept that’s easier for beginners to grasp. On the other hand, shorting involves borrowing shares, meeting margin requirements, and navigating rules like the short sale restriction.

Lower Costs

Long positions don’t require borrowing shares, so you avoid fees and margin interest. This reduces the financial burden, making it more accessible.

Fewer Risks

With long positions, your losses are limited to your invested amount. In short selling, the potential losses are theoretically unlimited if the stock’s price rises.

Advanced Short Selling: Challenges and Alternatives

Challenges of Advanced Short Selling

Short selling at an advanced level is not for the faint of heart. It requires expertise, quick decision-making, and the ability to manage significant risks. Short selling feels like starting with the cards stacked against you.

Here are some of the key challenges:

• Naked Short Selling: Risky and highly regulated, with potential penalties.
• Short Squeezes: Rapid price increases can lead to significant losses.
• Borrowing Costs: High fees and limited inventory reduce profitability.
• Short Sale Restrictions: Rules like uptick-only shorting hinder trade execution.
• Complex Tools: Using derivatives like put options or shorting ETFs requires expertise.

Alternatives to Advanced Short Selling

For traders who want to avoid the steep learning curve and risks of advanced short selling, there are safer and more accessible alternatives:

• Trend-Following Strategies: Profit from market trends without shorting.
• Diversified Portfolios: Use ETFs or mutual funds for safer market exposure.
• Put Options: Hedge against declines with controlled risk.
• Risk Management: Focus on diversifying long positions to minimize loss potential.

Common Mistakes Beginners Make With Short Selling

• Overtrading: Attempting to short every stock without understanding its fundamentals or market conditions.
• Ignoring Liquidity: Shorting illiquid stocks makes it difficult to cover positions.
• Poor Timing: Entering too early or too late can result in substantial losses, especially during short squeezes.

Conclusion: Mastering Trading Biases 

Short selling may offer opportunities, but it’s not without challenges. For beginners, starting with long positions is more practical, less risky, and easier to understand. Once you’ve mastered one strategy, you can consider expanding your skills to include shorting if it aligns with your trading style.

Ready to master long positions and build a solid foundation? Download Warrior Trading’s Ultimate Trading Strategy Guide and start your journey today!