If you’ve ever believed a stock would fall but were unsure how to profit from that, you’ll need to learn the basics of short selling. Short selling is a way to profit from a stock you expect to decline in price, and it starts with you selling shares in a security you do not own.
I know, that sounds impossible.
It isn’t, but you need to know the intricacies of the process; only then can you consider getting short in securities.
How short selling works
When you find a stock that your analysis says is due for a fall, you start the shorting process by borrowing shares from your brokerage firm to sell on the open market.
You capture the money from the sale. If the stock falls in price, you “cover” the trade, buying the shares back for less money than you paid for them, returning the shares to your brokerage firm and pocketing the difference, minus any interest charges.
In order to short securities, you generally would need a margin account; this lets you borrow money in order to sell stock that you don’t currently own. The Federal Reserve Board enforces short-selling regulations, and one of those rules states that only margin accounts can be used to short securities..
By rule, you are required to hold at least 1.5 times the market value of your short position in your margin account (meaning you would have the market value of the short position plus at least 50 percent of the market value of that position). Since you’re trading with “borrowed” money, you should only consider shorting stocks if you have an adequate amount of cash on account to hold onto your position.
Short selling can be difficult at first, but it has the potential to increase your profit potential. Never forget that shorting is a risky endeavor. Stocks could, theoretically, go to infinity, but the downside is floored at $0, plus your margin costs. Therefore, you need a high-risk tolerance to consider shorting stocks, and should only consider shorting if you have an adequate cash cushion to cover losses.
Jason Bond runs JasonBondTraining.com and is a swing trader of small-cap stocks.