How Short Selling Works

Let’s talk about what short selling is, how short selling works, the hidden costs of short selling, the risks of short selling, and also what a squeeze is.

Ever since we had the GameStop saga and AMC saga unfold everybody is talking about short selling, and how you can benefit from falling prices. So today I will show you exactly what this is all about.

What Is Short Selling?

Let’s first talk about what exactly short selling is, and I want to use Apple as an example. According to the chart below, AAPL is trading at pretty much exactly $150.

Now let’s just say that you are bearish on Apple and you say, “You know what, I don’t believe that this company is coming out with new innovations. I believe that the Apple price will go down.”

APPL - Apple Inc

And it really doesn’t matter what stock you’re using, I’m just using Apple because it’s trading at a nice round $150, $150.80 to be exact.

How Short Selling Works

So let’s say that this here is you being happy and saying, “You know what? I believe that Apple will go down, I want to sell Apple shares.” Now, here’s the challenge. You want to sell Apple shares, but right now you don’t own any shares.

How Short Selling Works

So this is where you can ask your broker, ” Could you please lend me some shares that I can sell to another trader?”

How Short Selling Works

So trader #2 comes into the picture, and he is happy because he believes that Apple is going up, while you believe that Apple is going down and is not worth $150.

How Short Selling Works

Here’s how it works. You’re actually asking your broker, “Hey, lend me some shares.” For this example, we want to say lend me 100 shares. You ask for 100 shares and the broker agrees.

There are some costs involved and we’ll talk about them in just a moment, but then you are just selling it to another trader who buys it. So now you sold 100 shares.

What Is Margin?

How Short Selling Works

Now, at some point, you have to give the broker these 100 shares back, and this is why the broker is requiring some so-called margin. I want to show you exactly what this means and what it looks like.

So shall we just sell 100 shares of Apple? Let’s just say that we want to sell Apple shares. It’s super easy. It’s equity, and we want to sell short. This is what this is called.

We want to sell 100 shares, so we place a stop order and input exactly $150.

Tradier - Sell Short

Now, first of all, we are selling short. At this point, my broker is requesting half of the money that these shares are worth as margin. This is absolutely normal because if I’m selling 100 shares, and each share is worth $150, this would be $15,000.

So this is also if you want to buy Apple shares. Going back to the other trader who wants to buy 100 Apple shares, he has to have at least $15,000 in the account.

Now, here’s the cool thing. My broker is giving me a break on margin, and this means a 50% break. So I only need to bring $7,500 to the table. This is important to know.

There are two important margin terms that you need to know. Number one is the initial margin. The initial margin is usually 50% of the shares that you’re borrowing from your broker. Then number two, we have a so-called maintenance margin, and we will talk about this in just a moment.

But before we do, let’s go back to the broker. Where is the broker getting these 100 shares from? The broker probably has shares of his own that he can lend out.

He probably has other clients as well, because there might be clients who have had Apple in their portfolio for a long, long time, maybe in their retirement account, right?

So he can actually take these shares and lends them to you, or if he doesn’t have them, he can even call other brokers and borrow 100 shares.

AAPL - Buy Low, Sell High

Let’s go back to our AAPL chart and continue in our example. Here we are at Apple, when you’re buying shares, the idea here is that you buy low and sell high.

AAPL - Sell High, Buy Low

Now, if you’re a short seller, if you are selling shares, this whole thing is flipped upside down. You want the stock to go down. So the idea is that you sell high and you buy low.

So you sold Apple at $150 a share. Now let’s say that Apple goes down to $130. In this case, you can buy these shares back from somebody who wants to sell them at this point.

What is your profit? Well, it is $20 per share, times 100 shares, this would be $2,000. So how much money did you make based on your investment?

We made $2,000, and as we just said, you only had to bring $7,500 to the table. $2,000 divided by the $7,500 means you’re making 26% based on your money.

What happens now in this whole scenario? Well, at some point you’re buying these shares back, and then you’re giving 100 shares back to your broker. This is how it technically works.

So let’s get back to margin again and what it means. The initial margin requirement, as you have seen, is 50%. Now, we also have a maintenance margin here and the maintenance margin is 30%.

What does it mean in our example? If we wanted to sell 100 shares of Apple at a price of $150, the value of this transaction is $15,000. At 50%, the initial margin would be $7,500.

The maintenance margin is 30% of this. So this would be about $5,000 for the maintenance margin.

What Happens If The Trade Goes Against You?

Let’s see what happens if Apple is actually going against you. What happens if you sold Apple at $150 and now Apple keeps rallying?

Let’s say that now Apple goes up to $180. So what’s happening? Since you are betting on a falling market you now lose money. How much do you lose? You lose $30 per share, and since you have 100 shares, you’re losing $3000.

What happens to your margin? Well, we had the $7,500 in initial margin, and now you’re losing the $3,000. So this is getting reduced by $3,000, meaning that now your margin is only at $4,500, which is below $5,000. This means now you’re getting this pesky margin call that everybody is dreading.

And you see, it doesn’t really matter if you are selling shares or if the big guy is doing it, hedge funds are doing it, or pension funds are doing it. At some point, if the stock goes up they are getting a margin call, and you would also get a margin call.

There are two options that you can do when you are getting a margin call.

You can wire more money into the account. How much exactly would you have to wire? Well, the difference here is between $4,500 and $5,000, so you would have to wire at least $500 in the account. That’s not a big deal. The problem starts if Apple keeps going up.

What is the other possibility that you have when you sold it back? When you sold the shares, you can buy them back, but now at a loss. So you would realize this $3,000 loss.

You see, at any given time you can buy it back from another trader who wants to sell with you, because this is how trading works, right?

I mean, there are people who want to buy and there are other people who want to sell. This is why we have the market because we all have different opinions.

Now let’s talk about what happens if this stock keeps going up, because this is when this so-called short squeeze is happening.

What Are The Costs of Short Selling?

Before we do this, let’s talk about the costs associated with selling shares. There are actually three different types of costs associated with this. The first cost is, you have to pay the broker interest rates.

The interest rate is on the margin that you are borrowing from your broker because you’re borrowing shares from the broker. In this case, it would be on the $7,500.

How much is this? This varies by broker. Right now most brokers are at around 5.25%. Some brokers are less, some brokers are more, but let’s just say you have to pay 5.25%.

Here’s the good news. You only have to pay this interest rate during the time when you are short these stocks. So if you take the $7,500 times 5.25%, this would be $393 per year.

Now, here’s the deal. If you only have these shares for 30 days, you would have to pay less. You only pay 30 days of the year. So a 12th of this, which would be a little bit more than $30, maybe around $40. Keep this in mind.

For the second cost, this is if the shares are hard to borrow, and this is where it says HTB, you might have to pay your broker a borrowing fee. Each broker decides how much this will be, so please check with your broker on how much this is. This is typically not for easy to borrow shares, but for hard to borrow shares.

Finally, for the third cost, you might have to pay dividends. What does this mean? Well, as you know, when you own shares, sometimes you’re getting paid dividends. Usually, they’re being paid quarterly.

Some stocks or ETFs pay them monthly. So if you are short the stocks, you’re not collecting dividends as you would when you’re actually buying shares. Now you’re on the other side, and if you’re on the other side, this means that now you have to pay dividends.

Again, this is usually not a whole lot and you don’t have to worry about that too much. You just have to keep in mind that these all are costs that are associated with when you are shorting stocks.

What Are The Risks?

Let’s go to the last two points here and talk about the risks. The risk is that you have unlimited risk.

GRPN - Groupon Inc.

Let’s say right now you’re bearish on Groupon, GRPN. You’ve been looking at Groupon recently, it’s trading at $25, and you believe it will continue to go down. This is where you would sell short at around $25 right now.

Now let’s think about it the other way for a minute. If you would buy Groupon, let’s say you’re buying 100 shares of Groupon for $25, your maximum risk is $2500 dollars because Groupon cannot go below zero.

I mean, the worst thing that can happen to Groupon, or any other stock that you’re bearish on, is it can go to zero. So your risk here is limited to $2,500.

However, what happens if you are short Groupon and it rallies up to $65? In this case, you would lose $40 per share, times 100 shares, for a total of $4,000. Think about it. Groupon could actually go much, much higher.

GRPN - Groupon Inc.

At some point, if you’re looking back, Groupon was trading at $260. What happens if it goes up to $260 and you sold it for $25? This is where you would lose $235 dollars, times 100 shares, for a total of $23,500. As you can see, your risk is almost unlimited.

Now let’s talk about this so-called short squeeze, and in order to do this, we’ll look at the most famous stock for short squeezes, GME.

GRPN - Groupon Inc.

Here is what happened at the beginning of 2021. GME at some point was trading at $40. As we said, you could have shorted it, or the big guys are shorting it. A few days later it went up to around $160, meaning that somebody that shorted GME would have lost $120 per share.

If we’re talking about 100 shares, this would be $12,000, and this is where you would get the dreaded margin call, meaning that you have two possibilities.

You can either put more money into the account or you’re buying it back at a loss.

This is where at some point people said, “you know what, I do not want to put more money in the account. I am actually buying it back.”

Think about it this way. This is where, again, this so-called short squeeze is happening. So we have people who already want to buy GME.

We also have all these short people, all the people who are short who have to buy it back. So you basically have a double whammy. This is why there’s a lot of buying coming into the markets right now.

What happens when you have a lot of buying coming into the markets? Well, this is when prices are skyrocketing, shooting up, and this is what happened here with GME.

This is why at some point GME went all the way up to $480 from initially around $40. This is where you can imagine, you would lose $440 per share. So if you traded 100 shares, that’s $44,000. This is what a short squeeze is.

I think it’s very important that you know what it means to go short a stock, because sometimes it is very, very appealing to say, “Oh my gosh, this stock is garbage, I’m betting on a falling market.”

But as you can see, there are costs involved and there is risk involved. The better way to do this would be by buying a put option, and I talk about this in my Options 101 playlist.

If you would like more information about the PowerX Strategy and The Wheel Strategy I have playlists containing videos explaining them, and you can check them out by clicking those links.

Read Next: Stock Trading Discipline And Patience – Trading Like A Pro

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