To short a stock is a high-risk investment move. While most investors seek to earn profits from companies that gain value, those who short stocks bet against companies in hopes that their share prices will decrease.
It sounds counter-intuitive — it’s a little hard to square the concepts of making money and betting on negative results. However, many investors have found success by selling borrowed shares and repurchasing them when they go down in value. In this post, Gorilla Trades explains the strategy and offers some insights into risks and tips concerning how to short a stock.
Short Selling Explained
When an investor decides to short a stock, they believe its price is going to drop in the near future. They “borrow” shares of the stock from their brokerage by placing a short order. After that transaction, the investor sells the stock to an outside party in the marketplace.
If the stock price drops as the investor expects, they buy the shares back at that lower cost and return them to the broker they borrowed them from. The investor keeps the difference between their original purchase price and the lower price they bought them back for, resulting in a tidy profit.
Of course, there’s always the chance that the stock price increases. In that case, the investor is in a tough spot. At some point, they’ll have to repurchase their shares for more than they originally paid and return them to the broker. In that scenario, the investor loses money.
Margin Accounts
Short selling requires the investor to open a margin account. This is akin to a line of credit. When you are using a margin account to buy long positions, the brokerage offers funds to buy stocks. But when you are using a margin account to short a stock, it becomes the vehicle for borrowing shares rather than money.
Say you want to short 100 shares of a company — we’ll call it Acme. Its current price is $50 per share. With your margin account set up, you place a “sell short” order. Your brokerage then sells the shares on the market for a grand total of $5,000. That amount is credited to your margin account like an escrow — it’s there, but you can’t withdraw it.
Weeks later, the Acme share price declines just like you expected — suppose that it’s now $40. You buy shares back for $4,000 and return the shares to the brokerage. You keep the $1,000 price difference as a profit, minus interest charges and fees.
Keep in mind that the Financial Industry Regulatory Authority (FINRA) requires you to deposit at least $2,000 in cash or equity to start a margin account. Your brokerage may also require a minimum ongoing balance above that amount. These minimums are needed to shield the brokerage from losses.
How to Short a Stock Step by Step
Here’s a rough breakdown of the process of shorting a stock.
1. Open a Margin Account
If you haven’t already, open a margin account at your brokerage. Remember that you’ll need at least $2,000 to start with.
2. Find a Stock to Short
Determine which commodity you want to short.
3. Find Shares to Borrow
Your brokerage may act as the middleman in finding stock owners willing to lend their stock shares. They may come from other investors’ margin accounts or the brokerage’s own inventory of shares. It may take some time to nail down these borrowable shares.
4. Place a Short Sale Order
Tell your brokerage you want to place a “sell short” order. Most online brokerages offer this option as a regular service.
5. Track the Position’s Price Movement
Keep a watchful eye and monitor how your position’s price changes. Wait for it to reach a low point, at which you’ll sell it for profit.
6. Close the Position
When the stock price has declined to the point you want, sell the shares back to the brokerage. You’ll pocket the difference between your original purchase price and the reselling price as profit.
Short Selling Strategies
Now that you know the process of short selling, how do you find commodities you expect to lose value? Here are a few bearish strategies and indicators you can rely on.
Fundamental Shorting
Companies with shaky stock market fundamentals are often targets for short sellers. These fundamentals are basic planks for judging a company’s value. Declining earnings, high debt-to-equity and price-to-earning ratios, market share decline, and industry disruption are some of the factors short sellers look for. This step will require a considerable amount of time and research.
Technical Shorting
Technical shorting uses stock price movements and chart patterns to identify ideal opportunities for shorting. When a stock price’s “peaks” and “troughs” over time suggest a gradual decline, it may be a good option for short selling.
Other pillars of technical indicators — moving averages, the relative strength index (RSI), and trading volume — can be deployed to find short-selling candidates. Stop-loss orders are necessary to contain risk.
Pairs Trading
Pairs trading, a good strategy in neutral markets, involves investing in two similar but distinct stocks with comparable price movements. If their price movements diverge, the investor takes a short position on the stock that’s declining and a long position on the more positive one. Profits are derived from the long-term gains of the outperforming stock and short-selling the underperforming one.
Event-Driven Trading
Many stocks experience brief recessions in value in anticipation of certain events — management shake-ups, corporate restructuring, pending bankruptcies, mergers and acquisitions, regulatory or recall issues, and others. To short these stocks successfully, it’s critical to stay on top of current events and expect a shorter time window.
Hype Shorting
Normally, it’s good advice to not believe the “hype” of certain trendy or meme stocks (the GameStop frenzy of 2021 is one example). However, if there’s any investment strategy that can take advantage of overvalued or hyped stocks, it’s short selling. The time window is even more brief for hype stocks, so be vigilant.
Risks of Short Selling
The risks of short selling are a lot more acute than with other strategies. In addition to traditional, across-the-board investment risks — market volatility, timing miscues, and regulatory issues — here are some adverse scenarios more specific to short selling.
Unlimited Loss Potential
Theoretically, there’s no limit to how high the value of a shorted stock can get. You may have to repurchase the shorted stock at a higher price than you originally paid for it, compounding your net losses. Stop-loss orders, again, are crucial to stem the damage.
Margin Call
If your shorted stock price rises too much, your equity in your margin account will dwindle. When that happens, your brokerage may make a margin call. This is a demand to deposit more funds in your margin account to restore your original equity level. If you can’t, the brokerage can close your position and crystallize your losses.
Dividend Payouts and Cover Fees
If you have a dividend-paying stock in your margin account, you’ll have to pay dividends out of your pocket. You’ll also be responsible for administrative or management fees. Both can cut into your profits.
Unavailability
For some brokerages, short selling is so risky that they may not allow their customers to take part in it. Make sure your broker is willing to lend shares to short before you start.
Be Mindful When You Short a Stock
Short selling is a modern strategy that’s paid off handsomely for adventurous and aware investors. Pay attention to likely candidates, limit your risk exposure, and get clear on timing and indicators to make it pay off for you.
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