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Beginner’s Guide to Shorting Stocks

As an investor, it’s wise to consider new ways to make money with the stock market. One advanced method to consider is the trading technique of shorting stocks. When you understand what it encompasses, you can decide if this is a wise choice for your financial situation. Use this beginner’s guide to shorting in stocks to learn more about this technique and its risks and benefits.

  • Shorting a stock is an advanced technique in which you borrow a stock, agree to buy it later to return the loan, and then sell it with the hopes of the price going down.
  • Though shorting stock comes with some benefits, there are several disadvantages as well, including only being able to make money when the stock prices go down and potentially having to pay a dividend to whoever you borrowed the stock from.
  • Despite short selling’s complex nature, it’s often the easiest way to profit from a company’s misfortune.

What Is Short Selling in the Stock Market?

Image via Unsplash by Markus Spiske

Also known as short selling, shorting stock is an advanced investment or trading technique where individuals take on a risk of capital loss by selling stock they don’t own or by selling shares they have taken on loan from a broker. Essentially, short sellers borrow stock, agree to buy it in the future to return the loan, and sell it with the expectation that the stock’s price will decline before they buy it back and return it to their lender. If they’re right about the stock and the price goes down, the rest is profit.

Shorting stock is considered an advanced technique because it involves plenty of experience and attention when it comes to timing. Use it only when you’re confident that an investment will drop in the short term.

Using this technique is often the easiest way to profit from a company’s misfortune. Despite its complexity, short selling allows you to make money while the portfolios of other investors continue to shrink. When used wisely, it can provide you with a substantial profit, though it certainly doesn’t come without risks.

What Is a Short Squeeze?

A short squeeze is a sharp increase in the price of a stock that was heavily shorted. This is a risk of short selling that comes with a market that follows supply and demand. It occurs when a stock doesn’t fall as expected. When this happens, short sellers buy stock to cover their short positions, which causes more short sellers to do the same in an effort to cut their losses. This buying pressure results in stock prices going even higher.

What Is Short Covering?

Short covering refers to the practice of buying stocks to “cover” an open short position. Large traders like hedge funds try to lower or eliminate the risk of short selling by short covering. Basically, short covering offers them protection against unexpected moves in the market.

When traders short cover, it gives them a neutral market position wherein they can exit with small profits and zero risks.

How Long Should You Stay in a Short Position?

Since there’s no mandate as to how long you can hold a short position, you have several options. Traders can enter and exit on the same day or stay for several days or weeks. It all comes down to your strategy and the stock’s performance.

What Are the Benefits of Short Selling?

When used strategically, short selling comes with several advantages for investors. Though it may seem obvious, short selling allows you to make money not just when the stock goes up but also when it goes down. Here are some additional benefits of this advanced technique:

  • It can provide your investment exposure with some diversity.
  • It allows you to get better returns compared to other investors who solely rely on stocks and other investments.
  • A short sale gives you the opportunity to reap a significant return without paying a substantial up-front cost.
  • It allows you to hedge your portfolio against a bear market. For example, if a financial crisis hits, having shorts may provide gains that offset the losses you may incur. Hedging is an option if you already own the stock, if you didn’t sell it before the market downturn, or if you think it’ll only lose its value.

What Are the Risks of Short Selling?

Though short selling gives you the opportunity to make a profit, this complicated technique comes with several risks investors don’t typically have to deal with.

When you buy a normal stock, the most you stand to lose is what you purchased it for. In other words, even when the stock goes to zero, you’ll never lose more than that. When the stock increases, there’s no ceiling as to how much profit you can gain.

When it comes to short sales, however, the role is reversed. Though you can only make so much in terms of a potential profit, there’s no limit to how much you can lose.

Here are some additional disadvantages that come with shorting stocks:

  • You only make money if the stock price goes down.
  • The broker can force you to cover the short on any day. This means that if the stock price is higher on the day that they want you to buy it (compared to the price on the day that the broker lent it to you), you’re out the difference in price.
  • It can turn a stock market dip into a stock market crash. Let’s say many investors or hedge fund managers attempt to short a company’s stock. Doing this can make the company bankrupt.
  • If you short a stock that pays a dividend, you have to pay it to whomever you borrowed the stock from. You also have to pay a broker fee for the service. When the stock price remains idle, you only lose the fee. However, when the price rises, you lose the fee and have to pay the higher stock price.
  • If your broker classifies the stock you’re shorting as “hard to borrow,” you’re required to pay a fee every day until you close the position.

If you decide to short sell, make sure to manage your risks appropriately.

Tips for Short Selling

If short selling is something you’re interested in, consider these tips to help you improve your strategy:

  • Don’t overpay for the insurance.
  • Consider the extra costs. For example, most brokerages have charge or interest fees when you borrow a stock.
  • Keep in mind that the U.S. Securities and Exchange Commission may place restrictions on who can sell short stocks. They may also restrict which securities can be shorted and how these securities can be sold short.
  • Be mindful of timing. Do your best to identify which stocks may be overvalued, when they might face a decline, and what price they could end up being.

How Do Hedge Funds Use Short Selling?

Hedge funds use this technique to turn a profit during instances like a stock bear market or a stock market crash. This is because the fund can sell it when it’s high and buy it when it’s low. In addition, it only gives them the up-front risk of the fee paid to the broker for the transaction.

Essentially, it allows hedge funds to make a substantial profit when they make the right move. Though they can face significant risks, they don’t usually use their own money. This means that they don’t have to pay for any mistakes using their own funds.

How Do You Short Sell a Stock?

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f you’re ready to tackle this advanced technique, use these steps to start short selling a stock:

  1. Borrow a security through a brokerage company that owns it. Contact your broker and look for stocks you think will go down. Once you find a stock, the broker will find an investor who owns the shares and borrow them with the promise of returning them later on. Once you have the shares, you’ll be required to pay fees or interest for being allowed to borrow them.
  2. Sell the shares you borrowed. Do this immediately and obtain the proceeds. Sell these with the hope of the price falling over time, allowing you to repurchase the stock at a lower price than its original sale price in order to make a profit.
  3. Wait for the stock to drop. Once the stock falls, buy it back at the lower price.
  4. Return the shares to the broker. Give the broker back the stock and keep the difference.

Now that you understand the short selling technique, determine if this method is right for you. Consider the pros and cons and make the best choice for your financial situation.