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How Can I Short the Stock Market?

As you become a more advanced trader, you can begin to explore trading strategies that require a high level of experience. One approach, in particular, is called short selling or shorting the market. In this guide, I’ll explain how to short the market and discuss some important aspects of short selling.

  • Short selling is when you borrow a stock, sell it, and then repurchase the stock before returning it to your lender. The idea is to buy the stock when it drops in price to make a profit.
  • When you get the timing right, short selling can lead to high profits. Other benefits include small upfront costs and being able to use it as a hedge.
  • Major drawbacks of short selling are its bad stigma, costly backend fees, and overall risk.

What Is Short Selling?

Image via Unsplash by Scott Graham

Short selling is an advanced trading strategy where you borrow a stock, sell it, and then buy the stock back in order to return it to your lender. The goal with short selling is for the stock you sell to fall in price. If it does drop in price, you can buy it back at a lower price and return it to the lender. Your profit is the difference between the selling price and the buying price.

Along with making a profit, investors can use short selling to hedge their investments. Hedging is essentially when you use risk-averse investments to protect your portfolio. They serve as a way to protect gains while limiting losses.

How Do I Short the Market?

When you short the market, you borrow shares from a broker-dealer and try to make money on them before returning the shares.

Investors follow these general steps to short the market:

  1. Open a short position. You first need to open a margin account and borrow shares from a broker-dealer. While the position is open, you typically need to pay interest on the value of the borrowed shares.
  2. Sell the shares. Right after borrowing the shares, you can sell them on the open market. The hope is that the price for these shares will fall over time so that you can repurchase them to make a profit.
  3. Keep an eye on your margin account. Rules enforced by the Financial Industry Regulatory Authority (FINRA) and the Federal Reserve state that there are minimum values for how much a margin account must have in it — this is called the maintenance margin. If your account’s value falls below this maintenance margin, you need to either add funds or risk having the position sold by the broker-dealer.
  4. Close a short position. Buy back the shares you borrowed on the market and return them to your broker-dealer. If you buy them at a price that’s lower than what you borrowed them for, you can make a profit. Account for any interest or commission you owe to the broker-dealer.

The Advantages of Short Selling

Since we often expect the market to grow, short selling can be a risky investment. That’s why only advanced traders tend to embark on this kind of trading. Here are some advantages to taking the risk and short selling:

  • You can use it as a hedge against other holdings.
  • It doesn’t require much capital upfront.
  • There is a possibility you will make impressive profits.

The Disadvantages of Short Selling

Of course, it’s still important to remember that every kind of investment comes with some potential drawbacks. Here are a few common reasons many traders stay away from short selling:

  • You have the potential for nearly unlimited losses.
  • You must open a margin account and follow regulations associated with it.
  • You need to account for margin interest and commission fees.
  • You only make a profit if the stock price falls.

Risks to Know Before Short Selling

A long with the unlimited losses discussed previously, you need to consider these risks when shorting the market:

Borrowed Money Adds Heightened Risks

When you short a stock, you are borrowing money from a brokerage firm. Essentially, they are using their investment as collateral since you need to pay interest and fees. It’s easy for your losses to become astronomical since you need to meet the maintenance margin. This is 25% of the total value of securities in your account. If you fall below this amount, you are hit with a margin call, meaning that you need to either add funds or that you must liquidate your positions until you meet that 25% requirement.

Timing Can Make You Lose Money

If a stock is overvalued and taking a while to drop in price, this could make you lose out on money. That’s because you are incurring more interest over time. Likewise, you need to continue to maintain your margin account in order to avoid a margin call.

A Short Squeeze Can Occur

A short squeeze is when a stock’s price rises, causing short sellers to repurchase their short positions to protect their trades. It the buying becomes a vicious cycle, stock prices can soar.

Regulations Can Lead to Loss

At times, certain sectors or the broad market may experience bans on short sales in order to lower panic and selling pressure. These bans can cause stock prices to spike, which can lead to significant losses for short sellers.

Betting Against the General Direction of the Market

Due to market growth and inflation, the price of a stock is usually expected to rise. When you decide to short, you are making a bet that the market will go in the opposite direction and fall.

Costs Associated With Short Selling

Short selling is a much more expensive type of investment than trading stocks and holding other types of investments. When you borrow shares, you need to account for these additional costs:

  • Stock borrowing costs: The broker-dealer decides how much you need to pay to borrow a stock.
  • Margin interest: Like any loan, you need to pay interest. If you are waiting a long time for a stock to fall, this interest can add up a lot.
  • Dividends: As a short seller, you need to make dividend payments to the stock’s owner. You are also responsible for payments in the event of share splits, spin-offs, and bonus share issues.

When Is the Best Time to Short the Stock Market?

Choosing the right time is the most crucial part of making a profit while short selling. The general trend is that stocks plummet faster than they rise. Entering the trade right when a stock takes a nose drive is how you can make a nice profit. If you hit it too late, you’re missing out on potential gains.

Here are some specific times you’re most likely to do well when shorting stocks:

  • When the market is bearish: By bearish, I mean that the market is experiencing a long-term price decline. It’s usually when securities fall 20% or more from a recent high.
  • When a stock’s fundamentals deteriorate: A stock’s fundamentals tell you the perceived value of a stock. Factors like slowing revenue, reduced profit growth, business challenges, and rising input costs can all lower this value. When trends indicate that the economy is falling, this can lead to a bearish market, which is good for short sellers.
  • When prospects for growth are too high: When a particular sector is doing considerably well, the market may become overly optimistic about long-term growth. When other traders’ high expectations aren’t met, short sellers can swoop in and make some serious money.

The Stigma Behind Short Selling

Short selling has a bad reputation since its key players are betting on the downfall of the stock market. They’re often seen as people seeking the destruction of companies.

The most realistic way to look at short selling is that it helps create enough sellers and buyers in the market. Along with this, it helps decrease the chances of bad stocks rising or over-optimistic trading. When investors see a lot of short selling in the market at one time, this warns them about negative fundamental trends or sudden news.

Of course, like with other types of investing, there are some bad eggs. Some short sellers may choose to artificially deflate prices and wreak havoc on sensitive stocks. Luckily, many types of market manipulation like this are illegal, but that’s not to say they never happen.

In order to short sell correctly, you need to have a solid understanding of the stock market. Over time, you may feel ready to try this more adventurous form of trading.