Can you short sell an ETF?

Exchange-traded funds (ETFs) are bought and sold on exchanges the same way stocks are. This means you can short sell an ETF, just as you can stock. Short selling is a way to speculate that an asset might fall in value – and earn a profit if it does. For example, if an investor thinks the tech sector as a whole might drop, that individual might short sell an ETF that tracks tech stocks.

Let’s dive into what short selling an ETF means, why you might want to do it and what to consider before you do, including the many risks.

First things first: What is an ETF?

To understand if you may want to short an ETF, it’s important to understand what ETFs even are. An ETF is a basket of securities that can be bought or sold on a stock exchange. ETFs can contain stocks, bonds or other securities and assets. When you buy an ETF, you own a small part of the whole pool of investments.

There are different types of ETFs, but most are designed to give investors exposure to a mix of assets. Some ETFs track a specific index, such as the S&P 500 or Russell 2000 Index. Others follow a specific industry, region or commodity. There are also ETFs focused on bonds or precious metals.

Can you short sell an ETF?

Put simply, yes, you can short sell an ETF. Short selling is an investment strategy that can allow traders to capitalize when markets are going down, but it comes with risks. If prices rise instead of fall, the strategy can prove costly.

Short selling – or “shorting” – is the opposite of being “long” on an investment, which means owning it with the expectation that the price will go up. Shorting a stock involves borrowing, which requires collateral. Because of this, investors usually need a margin account to be able to conduct a short sale. We’ll cover margin accounts later in more detail.

To short sell an ETF, an investor would borrow shares and sell them. Assuming the strategy pays off and the share price of the ETF falls, the investor would then repurchase the shares of the ETF and return the borrowed shares to the lender. The investor would profit from the difference in price minus the costs of shorting and any fees incurred.

For example, let’s say an investor wanted to short an S&P 500 index fund ETF when shares were worth $500. The individual borrows five shares, worth a total of $2,500, and immediately sells them. Over the next 10 days, the shares fall by 10%, and each share is now worth $450. The investor buys them back for $2,250, making $250 in profit, minus interest and other costs.

But what happens if the shares rise by 10% instead? In this scenario, the investor would have to pay $550 to buy back each share – for a total cost of $2,750 – ultimately losing over $250. There are ways to limit losses in short selling, including with a buy-stop order. Without such protections, though, losses can quickly spiral if prices increase rapidly.

Understanding inverse ETFs

An alternative to short selling ETFs is investing in inverse ETFs; these vehicles are a way for investors to indirectly short a specific fund or index. As their name suggests, these funds’ performance counters the benchmark they track. If an inverse ETF tracks an index that decreases in value, then the shares in the fund would be worth more. Bear in mind that these funds, which reset daily, are complex instruments that are not designed for buy-and-hold investors.

Why would you want to short sell an ETF?

You might want to short an ETF for several reasons. Maybe you think the sector or index the ETF tracks is about to trend downward, based either on your own technical analysis or on a broader investment hypothesis. In a hypothetical scenario, you might go short on an ETF focused on artificial intelligence (AI), for instance, because you think the AI sector is overpriced.

Short selling can also be a way to hedge against losses. Perhaps you have a lot of exposure to large-cap U.S. stocks, and you’re worried that geopolitical uncertainty could destabilize the market. Rather than sell your holdings, you might take a short position in an S&P 500 index fund ETF to help offset potential losses.

What should you consider before short selling an ETF?

Short selling ETFs isn’t a long-term strategy. Not only have prices historically trended upward overall, but the costs involved can erode profits if you wait too long. So before you start shorting ETFs, it’s important to understand the potential risks, the associated costs and your overall goals.

Interest and other costs can add up

When you short an ETF, you’re borrowing money. Interest usually accrues daily, and the rate varies depending on the liquidity of the ETF.

Investors must meet margin requirements

Brokerages may also charge commissions, margin interest and other fees. Finally, you’ll need to make any dividend payments that are owed to the lender during the time you’re short on the stock.

By law, investors can borrow only up to 50% of the security’s cost and must have a minimum of $2,000 in equity in their account. The rules are often even stricter for day traders. If the shorted ETF increases in value, it could push the investor outside their required maintenance margin. This in turn could result in a margin call – meaning you’ll have to deposit more money in your account or risk liquidation.

Shorting some ETFs may not be possible

Your brokerage may not be able to offer shorting on every ETF, as the firm must be confident that it can deliver the borrowed securities as promised. If a security isn’t very liquid, the brokerage may be unable to “locate” it. When this happens, the U.S. Securities and Exchange Commission (SEC) dictates that the brokerage can’t allow you to short the security. Part of Regulation SHO, which was introduced in 2005, states that the “locate” requirement aims to prevent what’s become known as “naked short selling” by ensuring that brokers have a reasonable belief that the shares can be borrowed and delivered on settlement, thereby reducing settlement failures and promoting market integrity.

There’s potential for uncapped losses

When you’re long on a stock, the most you can lose is the value of the stock itself. When you short a stock, however, there’s theoretically no limit to how high its price may go – so you could lose much more.

Let’s say you shorted 20 shares in a tech-focused ETF priced at $100 a share, totaling $2,000. The next day, there’s a sudden tech breakthrough or AI development, and the fund doubles in value instead of falling. Buying back those shares could cost you $4,000.

In practice, a buy-stop order could offer you some protection. This tool sets the price at which you’d attempt to buy back the asset if it didn’t perform as you expected. That said, if prices are moving rapidly, the order might not go through at the limit you set.

The bottom line

If you think an ETF is about to lose value, you might be able to either hedge against losses or turn a profit by short selling it. Short selling can be a risky and speculative strategy, though, so it’s important to understand what you’re getting into and to tread carefully.

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