A client has a long position in a security that is currently trading at $50 per share

Many successful traders profit from stocks that rise in value. But some do the opposite—profiting from stocks that decline in value—through a strategy known as short selling.

Short selling involves borrowing a security whose price you think is going to fall from your brokerage and selling it on the open market. Your plan is to then buy the same stock back later, hopefully for a lower price than you initially sold it for, and pocket the difference after repaying the initial loan.

For example, let's say a stock is trading at $50 a share. You borrow 100 shares and sell them for $5,000. The price suddenly declines to $25 a share, at which point you purchase 100 shares to replace those you borrowed, netting $2,500.

Short selling may sound straightforward, but this kind of speculative trading involves considerable risk. Here's a closer look at how it works—and what to consider before taking the plunge.

Getting started

Because you're borrowing shares from a brokerage firm, you must first establish a margin account to hold eligible bonds, cash, mutual funds, and/or stocks as collateral. As with other forms of borrowing, you'll be charged interest on the value of the outstanding shares until they're returned (though the interest may be tax-deductible). Interest rates can vary significantly—you may be able to short the most liquid shares for nothing, while the least liquid shares could come with an annualized interest rate of more than 100% of the value of your position—and even change suddenly if the shares become more or less liquid. Interest accrues daily at the prevailing rate and is deducted from your account on a monthly basis.

(Also worth noting: Your brokerage will have to have a "locate" for the security you're targeting before you can do a short sale. This is a regulatory requirement aimed at preventing "naked shorting," which is when a trader attempts a short sale without actually taking delivery of the borrowed shares. The rule says your brokerage must have a reasonable belief the security can be borrowed and delivered on a specific date before you can short it. Shorting in such a situation could lead to your position being closed by your brokerage, potentially resulting in significant losses or costs.)

Once you've opened and funded your margin account, you can start to research possible short-sale candidates. Traders typically use one or more of the following approaches to identify short-sale targets:

• Fundamental analysis: Analyzing a company's financials can help you determine if its stock may be a candidate for a decline in price. For example, when looking for short-sale candidates, some traders look for companies with declining earnings per share (EPS) and sales growth in the expectation that the company's share price will follow suit.
• Technical analysis: Patterns in a stock's price movement can also help you determine if it's on the cusp of a downtrend. One potential signal is when a stock has fallen through a series of lower lows while trading at higher volumes. Another could be when a stock rebounds to the upper range of its trading pattern but appears to be losing steam.
• Thematic: This approach involves betting against companies whose business models or technologies are deemed outdated (think Blockbuster Video), which can be more of a long game but can pay off should your prediction prove correct.

Entering a trade

As with any trade, you should identify your entry and exit points before you begin. You may also want to consider entering a stop order to help limit your losses in the event the trade moves against you.

In general, two kinds of stop orders may prove useful:

• Buy-stop orders trigger a market order to buy back the shares at the next available price if the stock price rises to or above the stop price.
• Trailing buy-stops specify a stop price that follows, or "trails," the lowest price of a stock by a percentage or dollar amount that you set. If the stock rises above its lowest price by the trail or more, it triggers a buy market order. If the price drops, the stop resets at a lower price.

However, neither method guarantees that the order will execute at or near the "stop" price you designate, and in fact, the stop order could lock in significant losses if the price gaps up.

Now for an example. Let's say stock XYZ recently dropped from $90 per share to $66 before rebounding to $84, and you think it's poised for another decline. After researching company fundamentals and analyzing recent price movements, you might decide on the following trade plan:

• Enter a short position only if the stock falls below $80 per share.
• Set your buy-stop order at $84 in the hope of limiting a potential loss to $4 per share.
• Close out your position at or below $74 per share.

Source: Schwab.com.

This example is hypothetical and for illustrative purposes only.

Understanding the risks

Short selling comes with numerous risks:

1. Potentially limitless losses: When you buy shares of stock (take a long position), your downside is limited to 100% of the money you invested. But when you short a stock, its price can keep rising. In theory, that means there's no upper limit to the amount you'd have to pay to replace the borrowed shares.

For example, you enter a short position on 100 shares of stock XYZ at $80, but instead of falling, the stock rises to $100. You'll have to spend $10,000 to pay back your borrowed shares—at a loss of $2,000. Stop orders can help mitigate this risk, but they're by no means bulletproof.

Losses for short-sellers can be particularly heavy during a so-called short-squeeze, which can occur when a heavily shorted stock unexpectedly rises in value, triggering a cascade of  further price increases as more and more short-sellers are forced to buy the stock to close out their positions. Each wave of purchases causes the stock's price to surge higher, hurting anyone holding onto a short position. 

2. A sudden change in fees. As noted above, the cost to borrow a stock changes frequently in response to supply and demand conditions. For example, you could log off one night with a short position carrying a 20% interest rate, only to log in the next day to find it has surged to 85%. As a result, you may find it no longer makes sense to keep your position open. Even worse would be a case where both the value of the stock you've shorted and the accompanying interest rate are rising at the same time, sending your cost to carry skyward.

(Schwab clients with StreetSmart Edge® can see both borrowing rates and availability for particular shares by adding them to their watch lists. Just click on the "Actions" drop-down menu and click "Columns & Settings." Under "Company Info" check the "Short Sell Borrowing Rate" and "Short Sell Availability" boxes.)

3. Dividend Payments. Short sellers aren't entitled to dividend payments from the shares they've borrowed. In fact, the value of any dividends paid will be deducted from short-seller's account on the pay date and delivered to the stock's owner. Some short sellers choose to close their short positions before the stock's ex-dividend date to avoid having to pay. (As a reminder, the ex-dividend date is the first day a stock's price no longer includes the value of a declared dividend. That's because the value of the next dividend payment is owed to the stock's owner.)

4. Margin calls. If the value of the collateral in your margin account drops below the minimum equity requirement—usually 30% to 35% of the value of the borrowed shares, depending on the firm and the particular securities you own—your brokerage may require you to deposit more cash or securities to cover the shortfall immediately.

For example, as long as your 100 shares of stock XYZ remain at $80 per share, you'll need $2,400 in your margin account—assuming a 30% equity requirement ($8,000 x .30). However, if the stock suddenly rises to $100 per share, you'll need $3,000 ($10,000 x .30)—requiring an immediate infusion of $600 to your account, which you may or may not have.

If you fail to meet the margin call, your brokerage firm may close out open positions to bring your account back to the minimum requirement.

Proceed with caution

At its most basic, short selling involves rooting against individual companies or the market, and some investors may be opposed to that on principle.

However, if you have a firm conviction that a stock price is heading lower, then shorting can be a profitable way to act on that instinct—so long as you're aware of the risks.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Short selling is an advanced trading strategy involving potentially unlimited risks and must be done in a margin account. Margin trading increases your level of market risk. For more information please refer to your account agreement and the Margin Risk Disclosure Statement.

Schwab does not recommend the use of technical analysis as a sole means of investment research.

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