You may have heard about short-selling, shorting or short position when listening to investment discussions, but maybe you weren’t quite sure of the meaning. Taking a short position is essentially the opposite of investing in a company. When you invest in a company, you’re betting that the price of the shares will go up, giving you positive wealth growth. When you take a short position, you’re betting that the price of a company’s stock is going to go down.
Taking the short position is a useful tool in the arsenal of any serious stock buyer. Once you learn how it is used, you can leverage it to earn some money when you think that a stock is overvalued and due for a serious dip in price per share.
Short Position Defined
A short position is an investing technique for exploiting overvalued stocks. Basically, you borrow the shares from an investment firm in order to sell them to another investor. Eventually, you have to return the shares you borrowed from the investment firm. The idea in a short sell is that you’ll sell the shares at a high price and buy new shares to give back to the investment firm at a lower price than you sold the borrowed shares. An investor can short other securities, including FOREX and futures, as well.
Short-selling requires a bit more foresight and general market knowledge than typical stock buying. Though it isn’t the most advanced investing technique, beginning investors may want to shy away from shorting until they are a bit more comfortable.
An Example of Short Position
Here’s an example of how taking a short position on a stock could work for an average investor. Let’s say you think that The Widget Company is overvalued and will see a big stock price drop after it reports its earnings next week. You borrow 100 shares of the Widget Company from an investment firm and sell them to another investor for $100 a share (a total of $10,000).
The company reports its earnings the next week. The Widget Company misses its target, sending the stocks into a dive — just like you’d predicted. You then buy 100 shares at $75 a share (a total of $7,500) and give those shares back to the investment company.
Minus any fees or interest you have to pay to the investment company, you’ve netted $2,500 by taking the short position.
Risks of Short Position
The main risk of taking a short position is obvious: If you’re wrong about the stock, you stand to lose money in the investment. In the above scenario, let’s say you were wrong about The Widget Company. Instead of reporting losses at their quarterly earnings, the company reports that the sales figures for their latest widget are through the roof. Thus, the stocks increase in value.
You still have to buy new shares to give back to the investment company, and now you have to buy them at a higher price than you sold the shares you initially borrowed. In theory, you could wait to see if prices go back down. But if the upward trend seems permanent, the longer you wait, the the more money you stand to lose.
For this reason, do careful research and think hard about taking a short position. In a normal stock trade, if the price dips, you can hold it and hope the price goes back up above what you paid. While you can wait for some time with a short sale, the investing company you borrowed from can demand you return its shares at any time. The company is more likely to do this if it seems unlikely that the stock price will go back down below the price at which you sold it.
Short Positions vs. Long Positions
The opposite of a short position, as you might guess, is a long position. A long position is what most people think of when they think of investing in stocks. Essentially, it’s buying shares in a company and holding on to them, in hopes that the price of the stock will go up. The goal is to eventually sell the shares for more than you paid for them, creating capital gains for yourself.
Put more simply, investors take a short position when they think the price of a stock is going to go down. They take a long position when they think the price of a stock is going to go up. Long position sales are much simpler than short positions. To take a short position, you must work with an investment company to borrow stock and then eventually buy stock to give back to the investment company. To take a long position, all you have to do is buy the stock through a broker and add it to your portfolio.
The Bottom Line
Taking a short position, also known as short-selling, is an investment technique in which you essentially do the opposite of what you’d do with a typical investment. Instead of buying the stock at a low price and hoping to sell it at a higher price, you sell it at a high price and hope to buy it later at a lower price. This works by borrowing stock to sell from an investment firm. You’ll then buy more stock later at a lower price to give back to the company. The risk is that the stock price may go up, forcing you to buy the return stock at a higher price.
- If you don’t think DIY stock-picking is for you, find a financial advisor to help you out. SmartAsset can help you find one with our free financial advisor matching service. You answer a few questions and we match you with up the three advisors in your area. We’ve vetted all of the advisors and ensured they are free of disclosures. Each of your advisor matches will then reach out to you so you can ask them any questions you have.
- 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.
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