Things you should know when shorting stocks

Shorting a stock means that you make money when the share price falls. In other words, it is a strategy that can potentially reward you who think the market, a commodity or a share will fall in value, and you will be right. But there is no one-size-fits-all investment strategy.

Imagine this: you lend your neighbor's lawnmower with the promise that you will return it at a later date. Then you resell the same mower, and wait for it to fall in value, so that you can buy it back for less than what you sold it for previously. You then give the lawnmower back to the neighbor - and keep the difference between what you sold and bought the mower back for.

This is, in principle, how shorting shares also works.

In this article, we will take a closer look at, among other things, shorting of shares, how to short shares, the risk of shorting, short squeeze and more.

PS: I would like to emphasize that shorting shares should be reserved for those who understand the risks involved, and that you should rather stick to long-term, safer investments if you are newbies in share investing.

Summary: Important points about shorting shares:

• To short stocks means that a trader borrows stocks and sells them immediately with the hope that the stock price will fall so that she can buy back the stock at lower levels.
• Shorting shares helps traders profit from share/market declines and acts as a hedge in the portfolio.
• But shorting a stock involves high risk, as the share's value can in theory go up without limit, which means that your loss can also be unlimited. Therefore, I believe that shorting stocks is reserved for professionals.

What is shorting of stocks?

A short trade occurs when a trader borrows shares from a broker and sells them immediately with the expectation/assumption that the shares will drop in value shortly afterwards. If the shares do this, traders can buy back the shares at a lower price, and keep the difference.

Example: You borrow 10 shares from a company and sell them immediately for $10 per share. That gives you a sum of $100. If the price falls to $5 per share, you can use the $100 to buy the shares you owe back for a total of $50 - which gives you a profit of $50 (not including commission).

Okay, that sounds simple enough, right? But there are a number of things you have to think about when short selling beyond understanding the concept and the risks of such a strategy.

How to short stocks

If you want to short a stock, you have to go through a quick test with the vast majority of online brokers which reveals whether you you have the right knowledge to use such advanced products or not.

Nordnet is an online broker that has such tests to identify whether you can engage in short trading. 

If you qualify for short trading, you must have a completely ordinary sell order, but you then choose a share that you do not already have in your portfolio.

The online broker (in this case, Nordnet) further lends the stock for you. When you want to close your position, simply place a buy order on the same share. 

 You never own the shares yourself, so this is a stock loan. This means that you must have a loan agreement activated on your account.

The position is closed when you have bought back the shares and the trade has been completed.

The technical aspects of short trading are not very difficult. Nevertheless, it is again important to emphasize the high risk involved in shorting shares, and therefore a number of security requirements are imposed on short trading, such as, for example, that you must have 15-100 per cent equity as security. 

You can read more about how shorting shares takes place at Nordnet's pages.

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Why short a stock?

There are several reasons why investors and traders may choose to short a share. Here are 5 different reasons: 

1. Hype. Traders can see that a company's stock price has risen massively in a short time, and believe that the buying frenzy cannot defend the high valuation the stock has now been given by optimistic investors.
2. An "evil" company. Or you have the case of Bill Ackman, who short Herbalife because of its pyramid scheme-like structure. There is a documentary (Betting on Zero ) which deals with this story. Recommended!
3. Worse macro outlook: Have you seen the movie The Big Short? If not, I can highly recommend it. The film deals with the true story of the investor Michael Burry, who saw what no one else saw - that the housing market, and thus the world economy, was headed for the cliff. Burry bet against the optimists in the market - and won.
4. A company on the way to the cliff: Gamestop was seen by a number of hedge funds as a company on the way to the abyss, with increasingly poor earnings and lower market share. We will return to Gamestop a little later in this article. You can find out which companies many have shorted by checking how high the company's "short interest ratio" is on sites such as Yahoo and Finanstilsynet.
5. Hedging in the portfolio:Shorting shares can also act as a hedge - i.e. a function that means you don't lose much if the market goes down, and you have a combination of long and short positions.

The 3 most shorted companies on the Oslo Stock Exchange

Below you can see the three most shorted companies on the Oslo Stock Exchange at the moment.

Ticker	Company
NEL	NEL
PGS	PGS
NOD	Nordic Semiconductor

Risks of shorting a stock

The very biggest risk you take with short trading is the risk of unlimited losses.

When you buy a stock in the traditional way, the most you can lose is what you paid for the shares. However, the upside is unlimited. So if you invest $10,000 in a share, you can lose a maximum of $10,000, but that can grow to a million and more over time.

With short trading, on the other hand, the opposite happens.

If a stock you have shorted falls to 0, you have reached the ceiling for what you can earn. But the losses you expose yourself to are, on the other hand, unlimited, since the stock price can rise indefinitely.

Let's go back to the example we looked at earlier:

You borrow 10 shares and sell them immediately for $10 per share, which gives you $100 in total. But this time the share price rises to $50 a share. Remember that when you short, you are obliged to give the shares you have borrowed back to the broker within a certain time, and this may mean that you now have to buy the shares back for a total of $500 - a much higher rate than what you sold for initially. This gives you a loss of $400. 

Or if the share continues to go down without you buying back, and it ends at $100 a share, you must now buy back the shares for $1,000. A loss of $900 for an investment of $100! 

One man's death is another man's bread

Abraham Germansky was a multi-millionaire real estate developer who made his fortune during "The Roaring Twenties». The economy flourished and Germansky wanted to continue making money, and therefore bet heavily on further growth in the stock market.

Then came that horrible week of October 1929 where the markets plunged and which shaped history as we know it today.

Germansky's portfolio took a real hit, to say the least. When his lawyer, Bernard H. Sandler, asked Germansky's wife the same week where he could get hold of Mr. Germansky, she replied that she did not know his current whereabouts. 

The last sign Germansky's whereabouts came from a witness who claimed to have seen Germansky walking down a street, apathetic in his gaze, tearing up a stock certificate.

Germansky, who lost everything in the stock market, was never found again.

On the other side, we have the contrast.

The same week, Jesse Livermore became one of the richest men in the world.

Livermore, who had already lost his entire fortune and rebuilt himself, had by 1929 accumulated large short positions, and in the spring of 1929 was down as much as $6 million. But then came the crash, which led to Livermore being able to walk away with a profit of over 100 million dollars.

He was nicknamed "The Great Bear of Wall Street", but was not exactly a popular man after the incident, and was blamed for much of the fall. He received several death threats, and had to have armed guards around him.

Livermore eventually took his own life in a hotel room, broke and depressed after losing his entire fortune a few years later. You can read more about his story in this article about trading .

What is a short squeeze?

A short squeeze occurs when the stock price rises so steeply that investors and traders who have shorted will be spooked into buying back the stock to limit their losses. This means that there will be more buyers, combined with hobby investors who grab a rising share, in pure FOMO.

Which drives the stock price even further upwards.

FOMO is short for «fear of missing out«.

When you close a short position, it means that you are actually buying back the stock that you borrowed and previously sold on.

Imagine the buying pressure that occurs in a stock if a group of short sellers are spooked into having to close out their positions by buying the stock (thereby initiating a further rise in the share price due to the buying pressure).

This is precisely what happened with the Gamestop stock.

The case of Gamestop 

A few years back, Gamestop stock exploded, driven by a large group of hobby investors from the Reddit group Wall Street Bets. They joined forces and bought shares 'en masse', which set the wheels in motion. When the stock price suddenly rose sharply, many hedge funds panicked and sold their short positions, which caused the stock price to rise even more and more hedge funds had to sell to avoid huge losses.

The price went from around 17 dollars a share to around 483 dollars a share in the space of a week.

I recommend that you check out the documentary "Eat the rich - the GameStop saga", if you want to know more about this story.

Some final words about shorting stocks

To summarize: short trading involves betting against a stock by borrowing shares, selling them immediately, with the aim of buying them back for a lower price at a later date.

This is an investment strategy that I believe is for the more advanced who understands the risks involved. 

Investors and die-hards who engage in short trading have often been accused of damaging companies (such as Bill Ackman and Jesse Livermore), manipulating stock prices, and spreading rumors about a company to damage its price.

On the other hand, shorts can also bring new information about a company to the table, causing people to pause and provide a more sober valuation of the company.