Short-selling involves betting on a stock with the expectation that its price will lose in value. It is an advanced trading strategy that focuses on making money from falling prices.
Instead of buying low and selling high, short-sellers will sell the shares first and then repurchase them, hopefully at a discount.
Short-Selling Explained
Short-selling, in a nutshell, is an investing strategy where you borrow shares of a stock with hopes that the stock’s price will go down. With this method, investors can put money into declining prices or gain some hedge in a position.
In the stock market, the usual strategy is to buy a stock for a lower price and sell it later at a higher price, otherwise known as going long. On the other hand, if you go short, you borrow shares from a broker and sell them right away on the market to other investors.
You then repurchase those shares, preferably at a discount, to close the position and repay the initial loan you owe the broker. If the stock’s price does lose value, as you predicted, you net the price difference minus interest and fees as profit.
In theory, short-selling is a pretty simple process, but its risks can be severe. You can lose money if you short-sell the shares and the stock’s price does not slide as expected. That loss does not yet include the fees to borrow the shares involved in this method.
Moreover, short-selling will require you to open a margin account with a broker, and borrowing shares will have you dealing with additional fees.
Looking Further Into Short-Selling
Short-selling focuses on generating profit from falling stock prices. It seems straightforward, but you should be careful with trying out this strategy.
Correctly seeing the opportunity to make money when prices are losing value is no easy task. That’s why short-selling is more popular with day traders than buy-and-hold investors.
Furthermore, you need to have a different perspective on assets and the market to go short. Short-sellers usually have a bearish view of the market, making them similar to contrarian investors since they typically take the road less traveled by the majority.
In looking for stocks to short-sell, the common approach is to keep an eye on the fundamental analysis of a company’s financials.
That way, you can find potential obstacles for the stock ahead, technical analysis of the stock’s past trading patterns, or come up with a logical situation for related drawbacks that will impact a particular stock sector.
Some market players short a stock, while others will short the overall market through strategies involving exchange-traded funds (ETFs).
Additionally, some traders include short-selling in their hedging strategy. For example, if you have a long position and are expecting prices to dip, you can short-sell to gain a hedge that would help curb losses on the position. The process of shorting the stock is the same, although the purpose for using it is different.
Using short-selling as a hedge will either protect some of the money you made or minimize the losses, depending on whether the prices rise or fall.
Shorting the Market Explained
As mentioned above, some traders may choose to short the stock market as a whole rather than short an individual security. That can be done by shorting an ETF that follows a market benchmark, like the S&P 500, although this is not the only way to short a market.
Inverse ETFs particularly take care of the preparations for a short sale on behalf of the investors. In fact, they do much of the work that traders don’t need to have a margin account.
Still, like with short-selling, what market players need to worry about with inverse ETFs are the market climbing and their potential losses increasing.
The Issue with Short-Selling
Short-selling carries plenty of risks, with the biggest one being the stock’s price soaring instead of falling.
The interest on your margin account and the risk you’re taking if the price keeps surging will also continue growing as you wait and wait for your trade to pay off.
In addition, you may have to consider depositing more cash in your margin account to avoid being subjected to a margin call and maintain your securities’ value at the required level.
Lastly, a short squeeze is an event you would not want to experience as a short-seller. A short squeeze occurs when a price in a stock that’s been short sold by many investors unexpectedly moves up, prompting short-sellers to exit to curb their losses.
Short-sellers then repurchase the stock, helping pump more strength in the stock’s price.
Considering the risks involved with short-selling and the margin requirements, you need to carefully think about whether it’s really worth going for this strategy or you’re better off using other investing methods.
Investing in put options offers a less risky way to turn a profit from declining prices. With put options, you are not required, although you have the choice to sell the underlying stock at the pre-determined price at a later date.
Steps to Shorting a Stock
Shorting a stock involves more than just one step. To short a stock, you need to do the following:
Open Up a Margin Account
A margin account is crucial to short-selling, as it’s what would allow you to borrow the money you need to purchase shares.
Opening a margin account involves meeting Financial Industry Regulatory Authority’s (FINRA) minimum requirements. You also need to make sure that your margin account maintains 150% of the value of the shares shorted.
Find Ideal Short-Sale Stocks
Once your broker green-lit you for short-selling, you need to find the right opportunity by looking into certain stocks.
Considering the risk of losing, it’s also vital that you develop a sound reason for why the stock’s price will dip, and it should be a reason based on an in-depth evaluation of the company and its stock.
Have a Plan
You need an entry and exit plan before the short sale. Here, your goal is to enter into the trade and exit the trade at a profit.
Your plan should consider the fees and the interest included in the borrowed amount. You may also need to think about having a plan b to reduce your losses if the stock’s price increases in value.
Start the Short Sale
Once you have done steps 1 to 3, you’re ready to start the short sale. Employing stop orders for trades could help carry out the trade as you planned. Plus, stop orders will eliminate any emotional factors that may interfere with your decision-making.
