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How Short Selling Works, and Why Its Losses Have No Ceiling

Short selling means selling borrowed shares and buying them back later. How a short sale works step by step, its costs, and why its losses are unlimited.

By Published 4 min read

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Key takeaways

  • A short sale is the sale of shares you do not own, borrowed through your broker, in the hope of buying them back later at a lower price.
  • The gain is capped at the sale price, but the loss is not: a share price can rise without limit, and you must still buy the shares back.
  • Short selling requires a margin account, and shorts carry their own maintenance requirements, borrowing costs and any dividends owed to the lender.
  • Regulation SHO requires brokers to have reasonable grounds to believe shares can be borrowed before a short sale, and restricts short-sale prices after a 10% one-day fall.
  • A short squeeze happens when rising prices force short sellers to buy, pushing prices higher still.

Buying a share, hoping it rises and selling it later is a "long" position. Short selling reverses the order. You sell first, with borrowed shares, and buy later, hoping the price has fallen in between. Investor.gov's definition is two sentences long: a short sale occurs when you sell stock you do not own; if the price drops, you can buy it back lower and make a profit, and if it rises and you buy back higher, you incur a loss. The asymmetry hidden in those sentences is the most important thing to understand about shorting.

A short sale, step by step

  1. Borrow. Your broker arranges to borrow shares, from its own inventory or another client's margin account, for example.
  2. Sell. You sell the borrowed shares at today's price.
  3. Wait. While the position is open you pay to borrow the shares, and if the company pays a dividend, you owe the lender an equal amount.
  4. Buy to cover. Later you buy the same number of shares in the market.
  5. Return. The shares go back to the lender, and the position is closed.

The SEC's guide to Regulation SHO adds that short sellers may be betting the price will fall, or may be hedging against swings in securities they already own. Shorting requires a margin account; it is not possible in a cash account.

The asymmetry: capped gain, uncapped loss

Short 100 shares at $20, receiving $2,000.

Price when you buy to cover Cost to buy back Result (before costs)
$0 $0 +$2,000, the maximum possible
$15 $1,500 +$500
$20 $2,000 $0
$30 $3,000 −$1,000
$60 $6,000 −$4,000
$100 $10,000 −$8,000

The best case is the stock going to zero, a gain of 100% of the sale proceeds. The worst case has no limit, because there is no ceiling on how high a share price can rise. That is the opposite of buying a stock, where the most you can lose is what you paid.

The extra costs

  • Interest on the loan. The SEC notes that, as with buying on margin, your brokerage firm charges interest on the borrowed shares, and you are subject to the margin rules.
  • Dividends. The lender expects any dividend; you pay it. How dividends work explains the dates that decide who is owed one.
  • Margin interest and requirements. Short positions need collateral. FINRA's Rule 4210 sets the minimum maintenance requirement for a short stock trading at $5 or more at the greater of $5 per share or 30% of current market value, and for one below $5 at the greater of $2.50 per share or 100%. Brokers may require more.

Margin calls and buy-ins

A rising price hurts a short seller in two ways at once: the loss grows, and the collateral required grows with the market value. Past a point, the broker issues a margin call, and if you do not meet it, the firm can close the position for you at whatever the current price is.

Short squeezes

Wikipedia defines a short squeeze as a rapid increase in a stock's price owing primarily to an excess of short selling rather than the underlying fundamentals. Short sellers buying to cover push the price up, which triggers more short sellers to cover, and the buying may happen automatically if they had placed stop orders. The result can be a cascade of purchases and an even bigger jump in price.

The rules that apply

The SEC's Regulation SHO governs short sales in US equities. Two parts matter most to individuals:

  • The locate requirement (Rule 203(b)). Before accepting a short sale order, a broker must have reasonable grounds to believe the security can be borrowed for delivery when due, and must document that "locate".
  • The price test (Rule 201). When a stock falls at least 10% in one day, a circuit breaker restricts the prices at which short sales may be executed, designed to stop short selling from driving the price down further. Market circuit breakers explains the market-wide pauses that work alongside it.

Why some investors short, and why it is hard

The SEC lists the purposes of short selling as profiting from an expected price fall, providing liquidity in response to unexpected buyer demand, and hedging the risk of a long position. Even when the view is right, timing is difficult: a stock can keep rising for longer than a short seller can afford to wait, while the costs keep running.

Short selling is one of the topics where practising without real money is most valuable, because the risks are lopsided. Learn to Trade Stocks Beginner teaches order types and risk with a virtual balance. It is one of our education apps, and the investing basics hub lists the related guides.

Good to know

Frequently asked questions

How does short selling work?
Your broker lends you shares, which you sell at today's price. Later you buy the same number of shares back and return them to the lender. If the price fell, you keep the difference; if it rose, you lose the difference, plus borrowing costs and any dividends paid while you were short.
Why are short selling losses unlimited?
Because there is no limit to how high a share price can rise. Short a stock at $20 and the most you can gain is $20 a share, if it falls to zero. If it rises to $60, $100 or more, you must still buy it back, losing $40, $80 or more per share.
What is a short squeeze?
Wikipedia describes it as a rapid price rise owing primarily to excess short selling rather than fundamentals. Short sellers buying back shares, sometimes automatically through stop orders, push the price up further, which can trigger still more covering.
Who pays the dividend when you short a stock?
The short seller. The person who lent the shares expects to receive any dividend, but the shares were sold to someone else who receives it from the company. So the short seller's account is charged an amount equal to the dividend.

Sources

  1. Short Sales (glossary) (opens in a new tab)Investor.gov, U.S. Securities and Exchange Commission — accessed
  2. Key Points About Regulation SHO (opens in a new tab)U.S. Securities and Exchange Commission — accessed
  3. Rule 4210: Margin Requirements (opens in a new tab)FINRA — accessed
  4. Short squeeze (opens in a new tab)Wikipedia — accessed

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