Shorting a stock looks very simple. But, this isn’t a strategy for beginners.
By Guy Avtalyon
Shorting a stock is when a trader borrows stocks and quickly sells them. She or he does that in the hope that can buy them back later at a lower price and return them to the broker or lender. Of course, the trader pockets the difference in the stock price. Shorting is riskier than simply buying stocks. A trader that practice shorting is taking a short position, while investors that are buying and holding stocks have so-called a long position.
In other words, when some trader starts short selling, he or she borrows stocks from an existing stockholder through the brokerage. Than sells borrowed shares at the current market price and takes the cash.
What is shorting stocks?
Generally speaking, when you invest in stocks, you expect to profit from a company’s great times and increasing profits.
But this is a whole different type of traders, called shorts. They do just the contrary. They search the Internet for news about car industry recalls, for example, and look for ways to cash when the stock of such a company is falling.
It’s possible to make money when prices are going down. Of course, if you are willing to accept the risks which are big. One of the strategies to profit on a downward-trending stock is selling short. The hope behind shorting a stock is that its price will decrease or the company will go bankrupt. Of course, it can lead to total ruin for the stock owners.
Shorting a stock means you are profiting if the stock price drops inside the timeframe from your entering the deal and turning back the stock. But if stock price increases, you’ll take a loss. You can short almost every asset, stocks, ETFs, and REITs, but never mutual funds.
What short-seller do?
The short seller is a trader who is buying the stock back but at a much lower price. However, the short seller must promise to return the borrowed stock at some period in the future. Otherwise, the true owner or broker will never borrow the trader a stock.
Borrowed shares have no dividends until the short seller turns them back. Even more, he has to compensate for missing payments to the lender from his own pocket. So, when short-selling it is very important to have accurate information.
When you want to close your short position, you have the obligation to buy the same number of shares at the current price and return them to the lender. Your profit or your loss comes from the difference between the price you sold the stock and the price you bought them for.
The stock for short selling can come from the broker’s inventory, a client of the firm, or from another brokerage company. When the shares are sold, the profits are added to your account.
How to shorting a stock
That involves some important steps. One of them is a short-term strategy.
Selling short is essentially created for a quick profit in stocks that you expect to decrease in value.
The main risk of shorting a stock is a possibility for the price to increase, and as a result, you’ll have a losing trade and losses. The possible stock price valuing is theoretically unlimited. Therefore, you are maybe exposed to great losses in a short position.
Also, shorting stocks involves margin. Hence, a short-seller can be subject to a margin call if the stock price moves up. A margin call requires a short seller to deposit additional money into the account to fill the initial margin balance.
Also, there are some restrictions on who can sell short, which stocks can be shorted, etc. You must be familiar with the regulation if want to short a stock. For example, some limitations are put on stocks wit low price.
Who can short stocks?
First of all, it isn’t for amateurs.
Unlimited losses and a margin account can be exceptionally dangerous for an amateur trader. Especially you don’t completely understand the risk you’ll face whenever you enter a short position without protection.
Due to the possible large losses that short selling generates, brokerages lower this strategy to margin accounts. In case you use a cash account without margin, you’ll not be allowed to short selling.
If you’re not a short seller and don’t like your stocks to be borrowed, the best option is to open a cash account. That will hold away short-sellers to borrow your stocks without your personal permission.
This is usually good practice, anyway.
Is timing important for shorting a stock?
In short, yes. The most important for shorting a stock is to know which one or more could be overvalued, also when it may drop, and when it may rise in value.
Shorting a stock is possible because the stock can be overvalued. For example, the housing bubble in 2008. Firstly, we had an enormous increase in housing costs. So, when the bubble popped we had a correction in the stock market. Remember, stocks can be overvalued or undervalued. In shorting is important to know which one is overvalued.
How long to stay in a short position?
You can enter and exit a short position on the same day. Or you may hold on the position for several days or weeks depending on the strategy and how the stock is performing. Timing is especially important to short selling. But the possible influence of tax practice is important also. So, we have to say, this is a strategy that requires practice and study.
Tools for shorting the stock
Shorting a stock is a strategy that demands to identify winners and losers.
For example, you may choose to go long a carmaker because you expect it’s possible to take market share. But, at the same time, you can go short to another carmaker that might sink.
Shorting is useful to hedge the current long position. For example, you hold stocks of the company and you expect it to decline in the next few months. But you don’t want to sell that stock. So, you could hedge the long position by shorting that stock while expecting it to decrease. When the stock turn to grow again all you need is to close the short position.
But you must be very careful.
Shorting a stock appears as very simple. But, keep in mind, this isn’t a strategy for beginners. Only the advanced traders who recognize the potential problems should think about shorting.
A valuable tool is the “short ratio”, you can see it specified for each individual stock. The short ratio commonly means how many days the stock needs to cover all the short positions. However, there is another benefit to that figure. It reveals the number of shares that are currently shorted by traders in comparison to the number of shares that are available overall.
How to get this number?
Multiply the current short ratio by the 30-day average daily volume of stocks.
Just use it as a quick measure of investors’ sentiment towards a stock. For example, a high short ratio usually shows the belief that stock is falling. There are some exceptions, but understanding those exceptions is the key to victorious short selling.