Betting against a stock means you’re profiting when the stock price declines. While most investors aim for stock prices to rise, betting on a fall can be a lucrative strategy when executed correctly.
Whether you’re looking at short selling or more advanced methods, this approach comes with its own risks and rewards. So, how to bet against the stock market—the right way?
In this shorting-a-stock-for-dummies guide, we’ll cover everything you need to know about these strategies and how they work.
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What it means to bet against a stock
When you bet against a stock, you’re essentially predicting that its price will drop. Investors do this by borrowing shares of the stock from a broker and selling them at the current price—with the hope that they can buy them back later at a lower price and return them to the broker, while pocketing the difference.
“Essentially, instead of buying low and selling high—the standard approach—short sellers aim to sell high and buy low,” says Dennis Shirshikov, professor of finance at the City University of New York.
So, how do you bet against a stock? Let’s say you want to short 100 shares of a company trading at $50 per share. You borrow and sell those shares for $5,000. If the stock price drops to $40, you can buy back those 100 shares for $4,000, return them to the broker, and keep the $1,000 profit.
However, if the stock price rises, you could face substantial losses. Betting against a stock is a high-risk, high-reward strategy, and it’s important to understand the mechanics before deciding whether you should dive in.
Short selling—the most common method
The practical details of betting against a stock primarily involve the process of short selling: You borrow shares, sell them, and then buy them back later at a lower price. The key is that you don’t own the shares you’re selling; you borrow them from a brokerage.
Here’s a breakdown of how to short a stock:
- Borrowing shares: To short a stock, you first need to borrow shares from your broker. These shares can come from the brokerage’s own inventory or from another investor’s account. You don’t own these shares but are temporarily holding them to sell in the market.
- Selling borrowed shares: After borrowing the shares, you immediately sell them at the current market price. Your goal is for the stock price to decrease so you can repurchase the shares at a lower price later.
- Waiting for the stock price to drop: If the stock price drops as expected, you can now buy back the shares at the lower price. The difference between the price at which you sold the stock and the price at which you repurchase it is your profit.
- Buying back the shares: To complete the transaction, you buy back the same number of shares you borrowed. If the price has dropped, you buy them at a lower price than what you sold them for, locking in a profit. If the price rises, you’re forced to buy them at a higher price, resulting in a loss.
- Returning the shares: Once you buy the shares back, you return them to your broker, fulfilling your obligation. You also pay interest or fees to the broker for borrowing the shares during the short sale.
Additionally, other elements like margin requirements, interest on borrowed shares, and potential fees can affect the process.
“It's important to note that short selling is highly risky because theoretically, the losses are unlimited,” Shirshikov says. “If the stock price rises instead of falling, you’ll have to buy the stock back at whatever its current price is, even if it’s significantly higher than what you sold it for.”
The opposite of shorting a stock is going long, which means buying shares of a stock with the expectation that the price will rise over time. When you go long, you are essentially betting that the company's value will increase, allowing you to sell your shares at a higher price in the future.
Other strategies for betting against the stock market
Betting against a stock isn’t limited to short selling. There are multiple ways to take advantage of a stock's decline:
Put options
A less risky way to bet against a stock is by purchasing put options. When you purchase put options, you are paying for the premium upfront. The premium is the cost of the option itself, which grants you the right, but not the obligation, to sell the underlying stock at the specified price (strike price) before the option's expiration date.
This upfront payment gives you the potential to profit if the stock’s price falls, without the same level of risk as short selling, because you have a maximum loss. “If the stock’s price declines, the value of your put option increases, allowing you to profit,” Shirshikov says. “The benefit here is that your potential loss is limited to the premium price you paid for the option.”
Potential cons:
If the stock doesn’t fall, the option could expire worthless, and you would lose your initial investment.
Inverse ETFs
Inverse exchange-traded funds (ETFs) are designed to move in the opposite direction of a particular index or sector. If you think the market, or a specific sector, is going to decline, you can buy an inverse ETF, which will increase in value as the index it tracks declines.
“For investors who don’t want to deal with the complexities of short selling or options, inverse ETFs can be a good alternative,” Shirshikov says. “This can be a more passive way to bet against a broad market trend without shorting individual stocks.”
Potential cons:
Inverse ETFs can be a safer option, but they’re generally not intended for long-term use. Many inverse ETFs use derivatives (financial instruments like options or futures contracts that derive their value from an underlying asset) to achieve their inverse returns, which can lead to losses if held for an extended period.
Shorting ETFs
In addition to shorting individual stocks, you can short ETFs that represent broader markets or sectors. This strategy allows you to bet against an entire sector rather than a single stock, potentially reducing the risk of shorting a single, volatile company.
Potential cons:
Shorting ETFs still involves borrowing shares, which means the risk is similar to shorting individual stocks. If the sector or market increases in value, you could face significant losses.
Bearish trading strategies
Aside from direct bets against stocks or sectors, there are a variety of other bearish trading strategies, including trading options spreads such as bear put spreads, which involve buying a put option and selling another put at a lower strike price to offset the cost. In theory, these strategies allow you to limit both your risk and reward.
Risks of betting against a stock
Betting against a stock, particularly through short selling, comes with several significant risks. Unlike traditional investing where your losses are limited to the amount you’ve invested, the risks of shorting can be far greater, as outlined below.
Unlimited loss potential
When you short a stock, your potential losses are theoretically unlimited because the stock price can rise indefinitely.
For example, if you short a stock at $50 and it rises to $100, $200, or even higher, you’ll have to buy it back at the new, elevated price, which could result in a substantial loss.
Margin requirements
A margin account is a type of brokerage account that allows you to borrow money from your broker to make trades. The margin account is necessary because it provides the collateral for the borrowed shares and ensures that the broker has security in case the trade moves against you.
Short selling requires a margin account, and you may need to maintain a minimum balance (margin) with your broker. If the stock price rises and your position worsens, the broker might issue a margin call, requiring you to deposit more funds.
If you can’t meet the margin requirement, your broker may liquidate your position, forcing you to realize a loss.
Stock price squeeze
A short squeeze occurs when a heavily shorted stock experiences a rapid price increase. This can be triggered by unexpected good news or increased demand for the stock. When this happens, short sellers rush to buy back shares to cover their positions, further driving up the stock price and intensifying losses for those still shorting.
Borrowing costs
Since you’re borrowing shares to sell short, you’ll pay interest or fees for borrowing those shares, especially if the stock is hard to borrow or in high demand. These costs can accumulate over time and eat into potential profits.
Dividends and corporate actions
If you short a stock that pays dividends, you’re responsible for paying the dividends to the person or institution you borrowed the shares from. Additionally, corporate actions like mergers, stock splits, or buybacks can affect the stock price, leading to unpredictable outcomes for your short position.
Timing risk
The stock you’re shorting may eventually decline but take longer than you expect. While you wait, the stock price could rise significantly, putting pressure on your position. Timing the market is notoriously difficult, and holding onto a losing short position can become increasingly risky and costly.
Market volatility
Market conditions can change quickly, and even a small piece of positive news can cause a stock to spike. Broader market trends, economic indicators, or unexpected events can also push stock prices higher, making short positions risky during periods of volatility.
Investors should have a clear exit plan and risk management strategy before engaging in short selling.
Tips on how to bet against a stock
Betting against a stock can be tempting, especially during market downturns or when you believe a company is overvalued. Here are some tips on how to bet against stocks:
- Do your research: Understand the company or market you're betting against. Why do you believe the stock price will decline? Look at financial reports, industry trends, and market conditions.
- Set clear limits: Decide in advance how much you’re willing to lose if the trade goes against you. Having a predetermined exit strategy can help you avoid significant losses.
- Stay informed: Keep an eye on market news and updates related to the stock or sector you’re betting against. Any major news event can impact stock prices.
- Understand the risks: Short selling and other bearish strategies can lead to significant losses. It’s crucial to only risk what you’re willing to lose.
By taking the time to research and setting clear risk management strategies, you can better position yourself to profit when stock prices fall.
FAQs
Is shorting a stock legal?
Yes, shorting a stock is legal. However, there are regulations in place to prevent manipulation and protect markets from excessive short selling. For instance, certain market conditions may trigger a “short sale restriction,” preventing new short sales on that stock for the rest of the day.
How to earn when the market is falling?
You can earn money during market downturns by using strategies like short selling, buying put options, or investing in inverse ETFs. These strategies allow you to profit when stock prices or markets decline.
How do you borrow against stocks?
When you short a stock, you borrow shares from your brokerage firm. The brokerage holds these shares on margin, meaning they lend them to you in exchange for a deposit or collateral. You’re then required to return those shares, typically by purchasing them on the open market at a later time.
Can you bet that a stock will fall?
Yes, short selling is one of the most common ways to bet that a stock will fall. You can also buy put options, short ETFs, or use inverse ETFs to take advantage of a declining stock price.
How do you borrow a stock to short sell?
To short sell, you must have a margin account with your broker. The broker lends you shares from their own inventory or from another investor’s account. You then sell those shares, and at a future point, you’ll need to buy them back to return them to the broker.