If you follow stocks at all, it’s quite likely you’ve heard people talk about “selling short.” But what is shorting a stock even mean? In this post, I’ll run through a few examples of how shorting a stock works, what the risks are, and why you probably shouldn’t do it.

What Is Shorting A Stock?

Shorting a stock is simply borrowing shares and then paying back the shares at a later date.

One thing to keep in mind here is that you’re borrowing the shares, not the money the shares represent. As such, if you short a stock you’ll need to pay back the number of shares borrowed (not however much the shares were worth at the time).

This means if you short a stock by borrowing shares and then the share price plummets, you can pay back the shares at a much lower cost and earn a profit. Here’s an example:

1. Shares are $100 a pop.
2. You borrow 10 shares and sell them.
3. You get paid $1000 in your account. But now you owe 10 shares that you need to pay back still.
4. The stock plummets to $70 a pop.
5. You spend $700 to buy 10 shares back from the market so you can return the 10 shares back to your lender.
6. You keep $1000 – $700 = $300 in profit. (Roughly, there’s some holding costs associated with shorting a stock which we’ll discuss later).

Conversely, if the stock goes up a lot, you’re still liable for your shares owed. Here’s an example:

1. Shares are $33 a pop.
2. You short the stock because you think the stock is just “hype” and it’ll fall soon. You borrow 100 shares and sell them.
3. You get paid $3300 in your account. But now you owe 100 shares.
4. The stock DOUBLES the next day to $66/share, and now you still owe 100 shares.
5. It’s hard to “buy to cover” your shares at $66/share because you’d LOSE $3300. So why not just wait until the market calms down?
6. It doesn’t matter if you’re patient or not, as it turns out. Your brokerage isn’t patient and issues a margin call. They notify you that you have to put a lot more money in your account, like, yesterday, or they’ll close your position for you and you lose $3300.
7. You think about what you should do in a panic-induced sweat. But before you can even make a decision, your brokerage closed your position for you and your account is now down $3300 (they took back the $3300 you got paid in step 3, and then also debited your account another $3300 because the 100 shares are worth a total of $6600 now). This is probably for the better, because you probably shouldn’t short stocks.

Holding Costs When Shorting A Stock

Because you’re borrowing shares, you need to pay an interest on the share generally. Otherwise, there’s no incentive for the lender to lend you the shares. It would be like allowing someone to lease your single family rental for free.

The interest varies wildly on shorted shares, and it depends on how much supply there is.

The fewer the supply, the higher the short interest. I’ve seen short interest range from 5%/yr to 99%/yr. The latter meaning, if you borrowed $10,000 worth of shares, you’ll need to pay $9,900 if you haven’t bought back the shares within the first year.

Because some stocks have a short interest of 99%+, you’re forced to double your money in a year to breakeven, or exit the trade a lot earlier. If your gut instincts are telling you that this is ultra-risky and completely unsustainable, you’re right.

Why You Should Never Do This

Shorting a stock is a horrendous idea. I’ll give you a few high-level reasons why and I’ll share a story of how I lost all my money in a short amount of time shorting stocks.

First, even though “stonks always go up” is a meme, there’s some truth to it. Stocks, generally speaking, skew towards increasing rather than decreasing over time. Just look at DJIA, S&P 500, or pretty much any decent company. Stocks are biased to be more expensive over time due to: 1) inflation, 2) businesses listed on the stock exchange generally grow, and 3) empirical data from various indices seem to indicate a strong bias towards stocks going up. Thus, shorting a stock is a very difficult way to make money as you’re betting against stocks’ strong bias upwards.

As Warren Buffet has said:

It’s a whole lot easier to make money on the long side. You can’t make big money shorting because the risk of big losses means you can’t make big bets.

Which is a perfect transition to story time about the risks involved in selling short stocks.

My Experience With Selling Short

In my high school economics class, we had a virtual trading competition. For a period of 2 weeks, we’d trade against each other and see who came out on top as far as profits go.

Anyway, I was dead last because I suck at trading. But then the teacher talked about “short selling” and I thought that’s quite an interesting strategy. My theory was this: if stocks go up like 50% overnight, it’s probably not sustainable and should revert to the mean. So I’d just short those stocks. In particular, I found pharmaceutical stocks that went up anywhere from 30%-120% and I’d just short them.

I’d make anywhere from 5%-10% of fake money each day. And I was a nervous wreck doing it – mainly because I wanted to win, really bad.

Why? Ego. We didn’t get a better grade for winning. We just get bragging rights, which you could argue is much more exhilarating than any “A+” grade you could get.

Anyway, I digress. The results: I did 100%+ in 2 weeks. Back in the day, Berkshire-Hathaway stock were worth roughly $100K/share. Our fake paper-trading accounts started with $100K. So after I doubled, I just bought 2 shares of Berkshire so people know I’m a gangsta.

So I told my mom about this and convinced her to let me play with $10K USD of real money. I gained 3% in the first day and she yanked the plugged immediately.

And thank fuck she did that because this high school competition is a very bad exercise and I wish I had never “won” – it would have saved me a lot of fucking money. Investing isn’t about trying to get max alpha within a 2 week period. That’s not investing. That’s retarded.

Fast forward many years later and I’m in the W-2 rat race. I got my first $10K and I started shorting shares.

I “only” made 20% in the first week.

Then I shorted something the next week and it doubled in the same day and I got margin-called. Poof. All my money gone within a day.

Wait, not even a day – within one session of trading.

The problem with shorting is that yes, it’s quite easy to make money. But it’s even easier to lose all your money. Shorting works like this:

• You might win 9 out of 10 times.
• But the 10^th time you’ll lose all your money, if not more.

This is not a robust investment strategy and in fact, it’s just a fool’s game. The 9 wins out of 10 is just monopoly money because the underlying strategy (shorting stocks) ensures you’ll lose all of it soon enough.

Cliff Notes

• Shorting stocks is just borrowing shares / selling them, and then paying the shares back at a later date. If share prices drop, then you profit the difference from the drop. If the share prices go up, then you lose a lot of money.
• Shorting stocks isn’t a good idea because the stock market tends to go up in general.
• Shorting stocks is like doing heroin: you’ll feel good a lot of times at the beginning, and then it pulls you into a deep pit of despair when you run enough iterations. It only takes one bad trade to destroy your net worth.

In summary, don’t short stocks and just purchase a safe index for the long-term.

P.S: If this post saved you from financial ruin, feel free to thank me at hello@goodmoneygoodlife.com. Or if you’re earning a ton of money shorting stocks and having lost all your fortune yet, please also e-mail me and keep me updated so when things go sideways I can reply “I told you so.”