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Trader Toolkit: Short Selling Basics

Jeff BishopJeff Bishop ·

Disagreement makes a market. It’s the fundamental premise of trading and the actions of buyers and sellers.

A buyer purchases stock from a seller, presumably thinking the position will gain ground while the seller believes the opposite. Buying the stock expecting it to go up is known as “going long,” but someone who is bearish on a security can go beyond merely selling it to “go short” and actively invest in a downturn.

Short sellers are bearish toward a stock; if they are wrong and the stock price rises, they will lose money, as surely as someone who goes long expecting a stock to rise comes up short when the price falls instead..

While the movie and book The Big Short glorified how traders got short the housing market before the financial crisis and made a fortune in the process, the truth is that many investors are scared to short stocks, largely because they don’t know the mechanics, risks and intricacies of the process.

Short Selling A Stock

Short sellers aren’t simply hitting the sell button and dumping shares they have been holding long. Instead, they borrow shares from a broker; you’ll need a margin account to do that. If they get those shares, they enter a short order, meaning that if someone wants to buy the stock at their offer price, they get paid for selling the shares now. They are now short that number of shares at that price.

If the price of the stock falls, the short seller has an unrealized gain. To cash in, they have to buy the shares back (thus returning them to the broker). Closing out the position is “covering” the short; if covered entirely below the entry price, the short seller realizes a profit as they go flat on the stock (eliminating their position).

On the other hand, if the stock rises above the short entry price, there are unrealized losses. Therefore, if the position is covered, the short seller comes away with a loss.

Keep in mind that these trades occur in a margin account, so a short seller should have enough cash set on the side, in case the stock rises significantly. If they need to replenish their margin account with funds, this is known as a margin call.

Example of a Short Sale

Source: TradingView

Consider this technical chart on the iShares MSCI Brazil Index ETF (EWZ). A short seller might believe the ETF could could pull back since it hit some resistance around the $40.50 area, and was above the upper bollinger band. That said, let’s assume the exchange-traded fund was on the easy to borrow list, and you opened a short sale of 100 shares at $39.50.

From here, if the price falls below that level, there are unrealized profits; covering the position below that level will realize those gains (which must be big enough to cover any interest on the margin account to deliver a net profit). If the price rises above $39. 50, there is a loss; repurchasing the shares stops that bleeding, realizes the loss and gets the short seller out of the position.

Final Thoughts

Short selling is a dangerous game, and it’s best left to traders with a high risk tolerance, and those with the cash to satisfy the margin requirement in case things get ugly. Keep in mind that these are the basic mechanics; shorting is a great way to play the market, but you’ll need to know a lot more before you can do it with confidence.

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