Short Selling Explained: Risks, Rewards, and Rules

Short-selling involves borrowing a security you expect to fall in value so that you can immediately sell it, wait for the price to drop, and then buy it back at a lower price. The difference between the price you sell the stock at and the price you repurchase the stock at, less associated costs, is your profit or loss. In this article, we’ll explain how short selling works step by step, what it costs, the risks involved — including the risk of a short squeeze — and some alternatives for investors who want bearish exposure without the complexity of shorting.

What is short-selling?

Short selling is an advanced trading strategy that uses borrowed shares and a margin account. You sell borrowed shares first and buy them later to close the position; you profit if the price falls and lose money if it rises. The most common securities shorted are stocks, though exchange-traded funds (ETFs) and bonds can also be sold short.

To short-sell, you need a margin account and thorough research. Short-sellers look for companies they believe are overvalued or facing headwinds.

Common research indicators include:

• Companies whose flagship products have not gained traction with consumers

• Stocks underperforming relative to peers in the same sector

• Sectors likely to face challenges or disruption

To close the position, you buy back the security in the open market and return it to the lender. If the price falls, you may be able to buy back at a lower price and keep the difference, minus costs.

If the price rises, you will buy back at a loss. Losses are not capped because the price can continue to rise. You’re obligated to return the shares regardless of how much you’ve lost.

How short selling works in 5 steps

Short selling can feel counterintuitive because you’re selling something you don’t actually own. Here’s the standard lifecycle of a short trade:

• Borrow the stock. You can’t sell what you don’t have, so your brokerage finds shares to lend you — usually from another client’s portfolio.

• Sell the stock immediately. You sell those borrowed shares at the current market price and the cash proceeds go into your account.

• Wait for the price to drop. You’re betting the price will go down so you can replace the shares cheaper.

• Buy the stock back. This is called “covering” your position. Ideally, you buy the shares at a lower price than you sold them for.

• Return the shares. The shares go back to the original lender. You keep the difference between the sell price and the buy price (minus fees).

Example of short selling

Let’s say an investor has been researching ABC Company for months and thinks the stock price will drop soon. They borrow 1,000 shares at $50 per share, then sell them for $50,000. Here’s what happens when they close the position:

Scenario 1: Price drops 20% to $40/share

• Buy back cost: $40,000 (1,000 shares × $40)

• Original sale: $50,000

• Profit: $10,000 minus fees

Scenario 2: Price rises to $75/share

Why do you need a margin account to short sell?

To short sell, you need to borrow securities which requires a margin account. The assets in the account are pledged as collateral against the amount borrowed to short-sell.

While holding a short position, you must have funds in your account to meet the minimum margin requirement. The Canadian Investment Regulatory Organisation (CIRO), which regulates investment dealers in Canada, sets minimum margin requirements. Brokers can set their own requirements as long as they are higher than CIRO’s minimums.

For example: if you short 100 shares at $10 per share with a 30% margin requirement, you’d need at least $300 in your margin account. The $300 margin plus the $1,000 from the short sale are held as collateral, totalling $1,300.

If the security’s price rises, you could face a margin call — a demand from your broker to fund your account. You’d need to close the position or transfer cash or securities to your margin account.

Short selling in Canada, at a high level

In Canada, short selling is a regulated activity with specific guardrails to protect investors and the market.

• No registered accounts. Short selling is not permitted in Tax-Free Savings Accounts (TFSAs) or Registered Retirement Savings Plans (RRSPs); it typically requires a non-registered margin account.

• The “uptick” rule has been removed for most liquid securities. Regulators such as CIRO may still impose restrictions during periods of extreme volatility.

• Borrowing is mandatory. Before you short, your broker must confirm a ‘locate’ for the shares; selling without borrowing (often called ‘naked shorting’) is generally prohibited.

Short selling costs and fees

Shorting is generally more expensive than buying and holding (“going long”). Before you trade, factor in these costs:

• Stock borrow fee. You pay interest to borrow the shares. For stable, large companies, this fee might be negligible. For volatile or popular stocks, the annual fee can spike to 50% or more because the shares are “hard to borrow.”

• Margin interest. If you borrow cash to meet margin requirements, you will pay interest on that loan.

• Dividends. This one catches many investors off guard. If the company pays a dividend while you short the stock, you don’t receive it — you owe it.

• Commissions. Depending on your brokerage, you may pay a trading commission to open and close the position.

Risks of short selling, including short squeezes

Short selling is widely considered an advanced trading strategy because the risk profile is different from buying a stock.

• Unlimited loss potential. When you buy a stock, the worst case is it goes to zero. When you short, the price can theoretically rise forever. If you short at $10 and it goes to $100, you’ve lost nine times your money.

• Short squeezes. A squeeze happens when a heavily shorted stock starts rising rapidly. Short sellers panic and buy shares to limit losses, pushing the price higher and forcing more short sellers to cover. This feedback loop can push prices sharply higher over a short period — as happened dramatically with GameStop in 2021.

• Buy-ins (forced closure). You don’t control the loan. If the lender wants their shares back or the brokerage can’t borrow replacements, you may be forced to buy back immediately at the current price — win or lose.

Why investors short sell

Given the risks, why do people do it? Generally, for two reasons:

• Speculation. Investors who have a strong conviction that a company is overvalued or facing a failing business model use shorting to profit from the decline.

• Hedging. Sophisticated investors use shorting to protect a portfolio. For example, if you own a lot of energy stocks, you might short an energy industry ETF to offset potential losses.

Alternatives to short selling

If you’re bearish on a stock but don’t want unlimited loss risk, there are alternatives:

Put options: give you the right to sell a stock at a specific price. The most you can lose is the premium you paid.

Inverse ETFs: also known as Bear ETFs or Short ETFs, they’re designed to profit when a specific index or benchmark falls in value – essentially they move opposite to an index or sector. They’re easier to trade than shorting but carry decay risks if held long-term.

Short selling can be powerful in the right hands, but understanding it is more valuable than doing it. If you’re building your investing foundation, start with investing basics before advanced strategies.

Wealthsimple’s Learn pages are meant to be educational. Every story is sourced from and vetted by subject matter experts, and produced by journalists with decades of media experience — people whose primary goal is to teach you something, rather than sell you something. While there may be links included in the article about products that are offered by Wealthsimple Investments Inc. (“Wealthsimple”) or one of its affiliates, these articles are not investment advice, a recommendation to buy or sell assets or securities, or any other kind of professional advice. If you are interested in learning about how Wealthsimple products or features work, please visit the Help Centre. If you are interested in knowing which products are offered by Wealthsimple and which are offered by affiliates, we’ve got a page to help you with that, too.