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 provides market participants with a way to profit if the stock price falls. This all starts with selling shares in a security you do not own. I know, that sounds impossible at first, but actually it’s done every day. Essentially, short selling is like borrowing money to help your friend buy an item. If the item costs less to buy than anticipated, you can pocket the price difference when you sell the item to your friend.
Of course, it’s slightly more complicated than that. You need to know the intricacies of the trading process; only then can you consider short selling stocks.
Short Selling Stocks Explained
When you analyze a stock and realize it could be due for a fall, you would consider short selling the name. However, you need to 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 would have unrealized profits. Now, if you want to take those profits, you “cover” the trade. In other words, you would buy the shares back for less money than you paid for them. Thereafter, you would return the shares to your brokerage firm and pocketing the difference, minus any interest charges.
Short Selling Stocks – Rules
In order to short securities, you need a margin account; this lets you borrow money in order to sell stock that you don’t currently own. This is part of how short selling works. The Federal Reserve Board enforces short-selling regulations. One of the short-selling regulations 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. That means you would have the market value of the short position plus at least 50 percent of the market value of that position. Remember, you’re trading with “borrowed” money. That said, you should only consider shorting stocks if you have an adequate amount of cash on account to hold onto your position.
Short Selling Stocks – Examples
Let’s take a look at an example now. If you wanted to short LongFin (LFIN) based on some technical analysis.
The first step is that you would need to see if your brokerage has shares available to borrow. If the stock is hard to borrow, you might need to pay a hefty fee to short the stock, especially one like LFIN, which has a low float and high short interest.
If you want to short sell stocks, you also need to have a really good reason, not just because the stock is “up too much.” The reality is, stocks go up and they go down. However, picking tops is a very difficult game. For example, you would not want to short penny stocks with a low float and high short interest. Why try picking a top when you can take part in the move higher?
Naked Brand Group (NAKD) announced a merger, and traders were trying to short this stock because it was “up too much”. However, traders in the community were buying this stock on pull backs. Our trading style involves buying penny stocks that had big moves and retraces to profit off of a potential move higher. NAKD held $8 well, so I bought 3K shares at $8.20 looking for a move above $10.
I took off the position a little early, but it’s always good to take profits.
Here’s a look at what happened with the stock.
Short selling can be difficult at first, but if you learn how short selling works 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. Moreover, you 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.