A Beginner's Guide to Shorting the Stock Market

Investors who expect stocks to decline have several ways to position a portfolio for falling prices. One is shorting the market, which can involve several strategies. You can sell borrowed securities, use inverse exchange-traded funds (ETFs), or buy put options tied to a broad market index. Short strategies can generate gains when prices fall, but they can also create substantial losses when markets move higher. Direct short sales are particularly risky because losses can theoretically be unlimited.

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What Is “Shorting the Market”?

Shorting the market means taking a position designed to benefit when stocks decline. Instead of expecting an investment to gain value, a short seller profits when the value drops. In a traditional short sale, you borrow shares through a brokerage firm and sell them. If the share price subsequently falls, you can purchase replacement shares at the lower price. Then you return them to the lender. The difference between the sale price and repurchase price represents the gross gain before borrowing costs, fees, and other expenses. If the price rises instead, buying the shares back produces a loss.

For example, assume you borrow a stock trading for $100 per share and sell it. If the price later falls to $75, you can buy a replacement share for $75 and return it. This produces a $25 gross gain before expenses. If the stock instead rises to $125, closing the position produces a $25 loss before expenses.

Investors can short individual securities, but a bearish position can also target a broader segment of the market. ETFs and derivatives tied to indexes such as the S&P 500 can provide broader exposure. They let investors track movements across many companies rather than a single stock.

Short selling also can be used as a hedge rather than solely as a bet on falling prices. An investor with substantial long exposure, for example, could establish a short position in a related security in an effort to offset some losses if the market declines.

How Do You Short the Market?

There are several ways to establish a position that may benefit from a broad stock market decline. They differ significantly in how they work and how much risk an investor assumes.

Inverse ETFs

One approach is purchasing an inverse ETF designed to move in the opposite direction of a particular index or benchmark. For example, an inverse ETF tied to a stock index generally seeks to gain when that index declines. Unlike a traditional short sale, purchasing an inverse ETF does not require you to borrow shares directly.

However, inverse ETFs require particular caution. Most seek to deliver the inverse of a benchmark’s performance for a single day and reset their exposure daily. Because returns compound from one day to the next, an inverse ETF’s performance can differ substantially from the benchmark’s cumulative return. Volatile markets can increase that divergence.

As a result, an investor should not assume that a correlation exists. An index losing 10% over an extended period does not mean an inverse ETF will automatically gain 10%. The SEC describes leveraged and inverse ETFs as specialized products that generally are not designed for buy-and-hold investors.

Shorting an Index ETF

Another approach is to short shares of an ETF that tracks a broad market index. If the ETF declines, you could potentially repurchase the shares at a lower price, generating a gain before expenses. If the ETF rises, the short position loses money.

Direct short selling requires a margin account. The brokerage firm must also be able to locate shares that can be borrowed for the transaction. Borrowing costs, margin requirements and other charges can affect the return.

Unlike ETFs, ordinary open-end mutual fund shares do not generally trade throughout the day on an exchange. You cannot short these shares in the same manner as exchange-traded securities.

Buying Put Options

Investors can also buy put options on an index or an ETF that tracks it. A put gives its buyer the right, but not the obligation, to sell at a specified strike price. The sale must occur within the period allowed by the contract.

A put can increase in value when the underlying security falls, although other factors affect its worth including the strike price, expiration date, volatility, and time remaining until expiration. If the anticipated decline does not occur before expiration, the buyer can lose some or all of the premium paid for the option.

Buying a put is different from directly shorting shares. With a purchased put, the maximum loss is generally limited to the premium paid, while an uncovered short sale can generate losses beyond the amount initially committed. Options can nevertheless be complex and may not be appropriate for every investor.

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Short Sale Risks

Illustration of a bear to represent a bear market.

The risk profile of a traditional short sale is fundamentally different from buying a stock. If you purchase a stock for $100, the most you can generally lose is the $100 invested if its value falls to zero. A short seller faces the opposite problem because there is no theoretical ceiling on a stock’s price.

Assume again that you short a stock at $100. If it rises to $200 before you close the position, the loss is $100 per share before borrowing costs and fees. At $300, the loss becomes $200. Because the stock could theoretically continue rising, the potential loss from the short position has no fixed upper limit.

Short sellers also face costs that long-only investors may not encounter. A broker can charge interest or other fees for borrowed shares. If the borrowed stock pays a dividend while the short position remains open, the short seller generally must make a payment corresponding to that dividend to the securities lender.

Margin requirements create another risk. If the position moves against you and the equity in your margin account falls below the required level, you may need to deposit additional cash or securities. Brokerage firms can also liquidate assets to address a margin deficiency, and FINRA notes that firms may be able to do so without first contacting the investor.

What Is a Short Squeeze?

A short squeeze occurs when a heavily shorted security begins rising rapidly and short sellers rush to close their positions. Closing a short requires purchasing shares, so this additional buying can push the price even higher and place further pressure on remaining short sellers.

A rapidly rising price can be particularly damaging because a short seller may face both mounting losses and higher margin requirements. Some investors may have to buy shares back sooner than planned, even if they continue to believe the security is overvalued.

The sharp trading activity involving GameStop and other stocks in early 2021 demonstrated how quickly heavily shorted securities can move. The episode also showed why a bearish assessment of a company’s fundamentals does not necessarily determine the short-term outcome of a short position. Timing, market liquidity and other investors’ trading activity can have a major effect on results.

Shorting the Market vs. Hedging a Portfolio

Taking a bearish position does not necessarily mean that an investor expects to profit from a market crash. Short positions and put options can also be used to reduce some of the risk created by investments already held in a portfolio.

For example, an investor with substantial exposure to U.S. stocks could buy put options tied to a broad stock index. If the market falls, gains on the puts could offset part of the decline in the investor’s stock holdings. If stocks rise, however, the investor could lose the premium paid for the puts while benefiting from appreciation elsewhere in the investment portfolio.

Direct short sales can serve a similar hedging purpose, but they introduce borrowing costs, margin requirements and potentially unlimited losses. The cost and risk of a hedge therefore need to be considered alongside the protection it is intended to provide.

Reducing stock exposure, increasing cash or changing a portfolio’s allocation to bonds are other ways investors may manage market risk without establishing a short position. These approaches have their own risks and can also reduce potential returns if stocks rise.

Bottom Line

Shorting the market is one way to seek gains from declining stock prices or offset some risk elsewhere in a portfolio. Investors can establish bearish exposure through direct short sales, inverse ETFs or put options, but these strategies work differently and carry different risks. Direct short selling can produce theoretically unlimited losses, while inverse ETFs can diverge substantially from the inverse of their benchmarks when held beyond their stated daily objective. Investors considering these strategies can weigh those risks against alternatives for managing market exposure.

Tips for Investing

Whether the market is going up or going down, the insights and counsel of a financial advisor can help you build a stronger portfolio. SmartAsset’s matching tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Whether you’re short selling or not, make sure you pay attention to taxes when you invest in the stock market. SmartAsset’s capital gains tax calculator shows how Uncle Sam impacts your gains.