The process of shorting a stock is like buying a stock in reverse and typically represents a bet that the stock will decline. Let’s imagine we own a number of tech stocks and are concerned that future interest rate increases may cause the market to go down. We might want to continue to own the stocks that we like, and to short the NASDAQ 100 (ticker: QQQ), a tech-heavy exchange-traded fund (ETF) to protect against the above-mentioned rate increases. (Please note that we are not recommending any specific investment; but rather, are providing a hypothetical example.)
Let’s say that based on your technology exposure, you wanted to short 1,000 shares of the QQQ. First, you’d borrow the 1,000 shares from your broker. For something liquid like the QQQ, that won’t be a problem. (Liquid means the security trades frequently and in high volume.) Some stocks can be classified as “hard to borrow” creating additional complications, but that won’t apply here.
Next, you’d go to the order entry box for whatever trading system you’re using. It will look something like this:
You’d set the number of shares to 1,000 in the “Quantity” box, set the lowest price you’d accept in the “Price” box, and click the red “SHORT” button in the lower right. Assuming your price was accepted, you’d then sell your borrowed shares. At that point, you’d have a cash balance from the sale, a short position in ticker QQQ, and would owe your broker the 1,000 shares you borrowed.
In this example, we assumed a “limit” order, which simply means that the trade will only be executed if it is at or better than the current price. Other types of orders include a “market” order, which ensures that your trade will be executed, but perhaps at unfavorable prices. There is also typically a “fill or kill” option which will only execute the order if you can buy or sell all of the shares indicated in the “Quantity” box.
Let’s say you completed the short sale of 1,000 shares of QQQ at the above price of $328.77, and subsequently, the QQQ declined by $5 to $323.77. Perhaps you might decide to close the trade at this point, which is referred to as “covering.” Now, you’d go back to the order entry box, check that the ticker still says QQQ, the quantity is still 1,000, and that your new price is $323.77.
The next step would be to click the green “COVER” button in the lower right corner. “Cover” means you’re going to buy the shares AND close your short position at the same time. In this example, you’d buy back the 1,000 shares of QQQ for $323.77 per share, and return the borrowed shares to your broker.
So, to sum up, you’ve borrowed 1,000 shares of QQQ from your broker, and returned the 1,000 borrowed shares making you and the broker “even.” The second part of the transaction was selling the shares for $328.77 each and then later, buying them back for $323.77 earning a profit of $5 per share. That $5 multiplied by the 1,000 shares you traded means a profit on this hypothetical transaction of $5,000.
In a typical stock trade, you try to buy low and sell high. In a short trade, you’re trying to sell high and then buy low. One area in particular where I would urge caution is to realize that losses on a short position are unlimited. When you buy a stock, if it goes to zero, the most you can lose is the amount you invested. When you short a stock, there’s no limit to how high that stock can rise, meaning there is no limit to your potential losses. Many prominent investors have recommended buying some great stocks, keeping them in your portfolio, and forgetting about them for months or years at a time. Taking that approach with short positions can be dangerous, and short positions need to be monitored closely.
Finally, this article isn’t intended to turn readers into portfolio managers, and I don’t recommend investing in ways that you don’t fully understand and which aren’t comfortable for you. Even if you’re not managing your own portfolio, there is great value in understanding alternative investment options and how professional investors think about and mitigate risk. At a minimum, you’ll be better prepared for a conversation with a trusted financial adviser in the future.
