While many investors strategize to buy stocks that are projected to increase in price, others try to profit on stocks with downward trajectories. This technique, known as a shorting a stock, can be quite valuable once you master the required shorting investment strategy. Read on for a comprehensive guide to everything you need to know about how to be a short seller.
What Is Shorting a Stock?
With stock shorting, investors take advantage of a short position rather than a long position to see a profit. What is a short position? While a long position means you think the stock will increase over your selected time period, a short position indicates you expect your target stock to decrease in value over the specified period. Although this strategy comes with some risk, it can also be quite rewarding for those who learn the ropes.
Let’s look at an example to highlight the steps involved in the short sale stock process. Let’s say you expect XYZ company stock to drop from $40 to $20 per share over the next week. You issue a short sale order with your broker to sell 2,000 shares of XYZ at the $40 price, earning you $8,000. However, you borrowed the money to purchase those original shares, so when the shares drop to $20, you pay back your broker at $4,000 and keep $4,000 as pure profit.
Although real-life short selling is more complex, this is the basic framework you will use for each transaction when investing in a short position. Follow these steps to get started:
- Set up a margin account.
- Choose a stock to short sell.
- Buy back short-sold stocks.
- Mitigate your risk.
Set Up a Margin Account
Are you wondering "where can I short sell stocks?" A margin account provides the capability to buy or sell stocks you do not actually own, like we did in the example above. Only certain types of brokers let investors make transactions with borrowed stock. Keep in mind that you must have enough money in your brokerage account to cover this type of transaction. Typically, your account must contain at least 150% of the total value of any short position you currently hold. In the example above, you could not execute that trade unless your account held at least $12,000.
Often, you must provide information about your liquid investments, stock strategies, and profit goals to establish a margin account. You must also sign a disclosure indicating your knowledge of the risk of short selling stocks. Look for margin accounts with low interest rates and limited fees to prevent cutting into your profit with exorbitant costs.
Choose a Stock to Short Sell
As with other types of trading, chart patterns and analysis provide the clues you need to find a stock that is poised to plummet and ripe to short. Timing is essential; ideally, you want to sell shares at the highest possible point and buy them back when they hit rock bottom to maximize profit with this strategy. Use these tips from expert investors to find the right stock to short sell:
- Use relative strength index (RSI) to compare industries and find a weak sector. These areas are more likely than hot industries to have a wealth of downward-trending stocks to short sell. In addition, your chosen stock’s relative strength should be lower than the 30-week moving average and the market index.
- Pair an indicator that a stock is overbought, such as the stochastic oscillator or the aforementioned RSI, with an indicator that the stock is on a downtrend. This trend indicator is often the stock’s short-term moving average.
- Look for a chart that indicates a bear market. This characteristically consists of a fast fall with a limited reversion bounce between an upper and a lower trend line. When a breakdown occurs with a trajectory that goes lower than the low trend line, the stock is poised to hit even lower lows. This is an optimal time to short sell that investment.
- Stay on top of the news. When you read about a company facing legal difficulties, financial troubles, or the impact of legislative changes, target its stock for a likely downtrend. However, learn to separate a small downward spike caused by current events from a long negative trajectory caused by a serious of misfortunes. For a good short sale, you want the latter scenario. Also, stocks with major news stories behind them tend to attract lots of attention, so they won’t necessarily create the short sale windfall you’re after.
Once you’ve landed on a stock you think might be on the downswing, enter a short sell with your broker. Typically, initiating this sale follows the same process as that of traditional transaction orders.
Buy Back Short-Sold Stocks
When you short sell a stock and it begins to trend upward rather than down, cut your losses and sell it as soon as possible. The longer the upward trajectory continues, the higher your likely profit decrease on that deal. Holding onto a short sale for too long in hopes it will change direction will rarely turn out in your favor.
For example, traders might try to artificially increase the stock price to avoid losing money to short sellers. When this occurs, you might be unable to sell your shares because no one is buying, as many other short sellers are also trying to unload this losing deal.
You can set a stop-loss order, which requires your broker to buy or sell an investment when it hits a predetermined price point. With short sales, you should set your stop-loss order to take effect when the investment hits above a certain price. This prevents you from losing more money if that stock continues to climb.
Mitigate Your Risk
Because of the risks inherent with this market strategy, you could lose a significant amount of your investment unless you are a very experienced trader before delving into short selling. However, you can limit your risk with these general guidelines:
- Avoid short selling high-priced stocks. The potential for a devastating loss increases with the value of your investment.
- Don’t short sell a stock based on price to earnings ratio alone. Instead, consider other metrics such as price to sales and price to book to confirm your suspicions about an investment’s trajectory.
- Only short sell stocks with daily trading volumes of at least 500,000 shares. If you do short sell a slower stock, keep your trade to less than 1% of the daily trading volume.
- Never short sell when facing a strong industry, strong market, or strong stock. All three of these components are typically weak in a successful short sale.
- Avoid short selling when you think a stock has reached a new high with the misconception that it can’t possibly go any higher and must start declining. In a strong uptrend that persists, the glut of short sellers attempting to get out of the market will leave you unable to recoup your investment.
- Limit short selling under unusual market conditions. For example, when options are expiring or the holiday season is near, you can’t trust investments to necessarily behave the way you expect them to.
- Diversify your portfolio. When a stock you hold seems to have limited prospects based on your analysis, it could be a good candidate for a short sale. On the other hand, hold onto stocks with defined and prolonged upward trajectories so you can sell them later for a handy profit. Relying too heavily on one trading strategy can limit your ability to realize the true potential of the stock market.
Raging Bull is your source for high-quality trading advice from real investment experts. Join us for incredible resources such as our free trading e-book, and sign up for a webinar session with an experienced trading guru. We can’t wait to show you how to conquer the market and become a successful investor.