Shorting a stock is one of the most common phrases thrown around in financial markets. Most investors know that shorting is an attempt to profit from a stock’s decrease in price. Still, it can be a bit tricky to understand all of the mechanics behind shorting a stock. Does shorting a stock make its price go down? And by how much?
Shorting a stock will make its price go down. While small-scale shorting is unlikely to have much impact on stock price, high-volume shorting will put significant downward pressure on the stock’s price.
Although shorting will most likely lead to reductions in stock price, it is the volume that will ultimately carry the weight. In addition, there is a scenario known as a “short squeeze” in which rampant shorting can actually cause price appreciation. To clear all of this up, keep reading to find out everything there is to know about shorting’s effect on the stock price.
Does Shorting a Stock Reduce its Price?
Yes, short selling reduces the price of a stock. The volume of short trading activity will determine just how much the price drops.
When traders short a stock, it introduces a large supply of shares into the market, which puts downward pressure on the stock’s price.
From Economics 101, we learn that as supply increases, demand falls. When demand falls, sellers have to reduce the price in order to entice people to buy.
While this is the general principle for how shorting a stock reduces its price, you shouldn’t automatically assume that shorting a stock is a foolproof way for making its price go down.
If you are a beginner trader and only have enough funds to short a handful of shares, your short transaction will have a negligible effect on the stock price. Most stocks trade with a volume of millions of shares per day.
However, a barrage of short-selling activity around a stock from many investors, or a monstrous short trade involving hundreds of thousands of shares, will undoubtedly cause the price of a stock to plummet.
But even with that, there is a caveat.
What Happens When the Price Falls too Low on a Shorted Stock?
Too much short selling will cause a stock’s price to drop to a point where it is extremely attractive to investors. When it hits this point, there will be a significant market of investors ready to scoop it up at a low price.
When this phenomenon of shorted shares being immediately bought occurs, short traders are forced into what is known as a “short squeeze.” This means that short sellers have to buy back shorted shares to stem their losses.
So when too much short selling causes the stock price to reach this point, it can be argued that further short selling will actually cause the price of a stock to rise, as it induces an onslaught of buying activity.
Nonetheless, this is the exception, and shorting a stock will generally cause the price of shares to go down.
How Can You Lose Money Short-Selling Stock?
You lose money short-selling stocks when the price of a stock goes up.
In simple terms, a short sale is a bet that the price of a stock will drop. Therefore, any increase in price is a losing scenario for a short trader.
However, it is important to note that a short trader does not realize any losses until the trade closes. This would be the point that the short trader buys back the borrowed shares and returns them to the lender.
This may occur when the contract on the borrowed shares comes due or when the short trader believes they have entered into a bad trade and wants to cut his or her losses.
Let’s show you how this works.
Losing Money When Short-Selling: An Example
A short trader borrows 100 shares of Stock X at $10 per share, sells them and receives $1,000 cash for the shares.
If the price of the stock immediately surges to $20 per share, the short trader has not realized any losses–even though their investment is looking bleak. On the books, they will have to pay $2,000 to buy back the shares sold for $1,000 (representing a $1,000 loss), but nothing is realized until the trade is closed. The trader can continue to wait for the price of the stock to drop.
Now, let’s say that the price does drop back to $15 per share. Even though this is still not lower than the original $10 per share purchase price, the trader decides to buy the 100 shares back at this price because the sentiment surrounding the stock has turned decidedly bullish and the trader wants to prevent any further losses.
Therefore, the trader has to pay $1,500 to buy back the original 100 shares that were borrowed. Remember, these 100 shares only returned $1,000 of revenue at the original $10 per share selling point, so the trader has to buy the shares back for $500 more than what they sold for. This would represent a 50% loss on the short trade.
How Much Money Can You Lose From Shorting Stocks?
In theory, you can lose an unlimited amount by shorting stocks.
As there is no upper cap on how high a stock’s price can go, incorrectly timing a short trade can result in you having to buy back the borrowed shares at a price many, many times higher than what you paid for them.
This is what makes shorting stocks inherently riskier than taking a traditional buy-and-hold approach for stock appreciation.
If you buy 100 shares of Stock X at $10 per share with the idea of holding them for the long term and watching the shares grow, the most you can possibly lose is $1,000. If the stock tanks and the share price goes to zero, you only stand to lose that initial $1,000 investment.
The downside with shorting is much scarier. If you borrow 100 shares of the same Stock X at $10 per share, with the idea of buying them back at a lower price in the future, a major surge in stock price can be catastrophic. If Stock X goes through the roof and appreciates to $1,000 per share, you will have to buy the shares back for $100,000–representing a $99,000 loss on your initial investment.
Due to this risk, short traders have to monitor their trades very closely and exit unsuccessful trades quickly to prevent such a scenario from occurring.
Final Verdict: Does Shorting a Stock Make Its Price Go Down?
Shorting a stock will make its price go down. Although small short trades will likely have a limited impact on stock price, trading in heavy volumes will put significant downward pressure on the stock’s price, due to the influx of supply introduced to the market.
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