With Tesla (NASDAQ: TSLA) making headlines this week after a blowout Q2 earnings report, we thought we’d break down what is short-selling, and the pitfalls attached to the practice. Especially when considering Tesla and CEO Elon Musk’s ‘difficult’ relationship with short-sellers.
- Just like you can bet on a stock rising, you can bet on it declining.
- This is called short selling or shorting.
- Technically short selling can lead to unlimited losses.
Disclaimer: We at MyWallSt in no way endorse short selling. Some people make a lot of money doing it, but really, it’s something that should be left to the speculators and day traders. This blog post is purely to educate you on the practice.
Just like you can invest in a company and make a return when the value goes up, you can bet against a company and make money when its value declines. It’s called short selling.
How Does Short Selling Work?
To do this you’ll need a margin account with your broker (again we highly recommend against this too), as technically you could incur unlimited losses.
For example, if you wanted to short Netflix (NASDAQ:NFLX) or Uber (NYSE:UBER), two other highly shorted stocks, in practice you would borrow a stock from your broker using credit. If the stock price drops 10%, you can then buy the stock at the lower price and make a profit on the difference. If the stock price goes up, however, you may be forced to buy it at the higher price to pay back the owner.
The Risks of Short Selling
Since the lowest a stock price can go is zero, when you buy a stock, the most you are going to lose is the money you’ve invested. When short selling, there is no limit to what you could lose, as the price could continue to rise indefinitely.
When you short a stock you are not entitled to any dividends or shareholders rights, as you are only borrowing the stock. To further complicate things, if demand for the stock goes up, your broker can force you to return it if the original owner wants to sell. So even if the price has gone up, but you still expect it to drop, you might have no choice in holding onto the stock and be forced to incur a loss.
If you’re interested in learning more investing basics, check out our other posts:
- Everything you need to know about investing
- What is a stock split?
- What is after-hours trading?
- What is a dividend reinvestment plan?
MyWallSt operates a full disclosure policy. MyWallSt staff currently holds long positions in Netflix, Beyond Meat and Tesla. Read our full disclosure policy here.
Financial Analyst at MyWallSt
Michael's first and favorite stock is Square, which he sees becoming a massive player in the payments industry and a leader in the war on cash.