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Short Selling – Full Guide For Beginners

Short selling is a risky business and not ideal for the average investor. However, it can be a great tool for professionals. In this article, we review the basics of short selling - how does it work, what's the main things to consider and of course, the risks.

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Table Of Content

Have you heard of short selling and short sellers? Maybe you have read on the media that they are speculators and manipulators and they “distort” the market. This is not entirely true since all players influence the market as well as each other’s performance.

What is short selling, however? How does it happen and what is the mechanism of it? Is it appropriate for you or not? Are there any alternatives to it? I will answer all these questions in this article.

What is Short Selling?

Of course, short selling is not an easy job. Simply put, short selling is the process of selling securities which an investor doesn’t own. Sounds strange?

The logic behind it is not, though. Short sellers sell something at a high price because they believe that in the future they can buy it back at a lower price, thus making some profit. How do you sell something you don’t have?

Well, loans, remember? You actually borrow a security from a person or a company that owns it. Just like in loans, you need to pay interest because you use someone else’s stocks. Short sellers pay fees to the owners. What will happen if the price goes up when a short seller sells the stock instead of going down as planned?

In such a case, you will have to pay additional money to buy the stocks at a higher price than you borrowed it. Therefore, the amount of profit a short seller can make is the difference between the two prices: the sale price and the purchase price.

Keep in mind – short selling is riskier than the normal way of investing in stocks.

If an investor purchases some stocks all they can lose is the value of these stocks. But when you borrow something and you pay fees and eventually the value of the stocks plummets, you can be a big time loser.

Example of Short Selling

Still cannot get the idea? Well, let me give you one easy to understand example.

John wants to try short selling. He goes to Adam and wants to borrow from his stocks which currently trade at 50$ apiece. Adam agrees to lend him 1000 shares at 50$. For that, John has to pay a fee because he uses someone else’s assets.

Why does John want so eagerly to short sell? Let’s imagine he has been doing research for 6 months and he’s estimated that the mentioned stock will lose its value in the next month. In his trading account, John has 1000 stocks each at 50$. He sells them and receives $50,000. Part of this money will be kept as collateral (protection against losses). After the sale, there are two possible scenarios:

1) The price of this stock does indeed fall in the next month to 35$ per share. John, therefore, buys back all the 1000 shares and pays for that 35,000$. His gross profit is the difference between the prices – 15,000$. Gross is not net, you know. He has to pay fees and other costs.

2) The price of the stock goes up to 60$ per share. The amount you have to pay for buying these stocks is 60,000$ meaning that John has generated 10,000$ of losses.

Scenario Revenue Profit
35$ per share 35,000$ -15,000$
60$ per share 60,000$ +10,000$

The amounts of profit or losses in the example are gross. Keep in mind, anyone dealing with buying or selling stocks will have to pay various fees, costs, and commissions along the way.

How to short a stock 

The process begins when you identify a stock that is about to dive. Next, approach your broker to borrow these stocks so that you can sell them at the current market price.

Once the market meets the conditions, you buy the stocks at lower prices which satisfy your returns goals. Lastly, return the borrowed stocks to the broker, settle any fees and enjoy the profits. The profits, in this case, is the difference between your borrowed selling price and current buying price.

The process is done automatically through your broker trading system – just make sure your account has the right permissions for short selling.

Benefits of Short Selling

Investors short sell for three main reasons:

  • Speculation

This is the most common reason for an investor to short a stock.

Some of them may read that the market has overvalued a company, or the company may make some negative announcements or be the subject of negative publicity, all of which may have a negative impact on the price. In such a case, a short position would provide an easy way to profit, as long as the forecast is correct, of course.

Successful speculation is not a result of chance, but of extensive research, experience, and perfect timing. Historically, the stock market has been on an upward trend.

  • Hedging

Short selling allows you to hedge an existing portfolio's long-only exposure and reduce a portfolio's overall market exposure. Incorporating short-selling into your investment strategies doubles your profit opportunities because you can profit from both stock price increases and stock price decreases.

Investors typically short sell their stocks in order to hedge their positions. In this case, the hedge is used as a form of ‘insurance.' They essentially take an investment position that protects them from the possibility of a loss.

For example, suppose an investor owns shares of Company X as a long-term holding. He may be counting on dividends to support him during his retirement. An impending quarterly report might not paint a good picture and may cause analysts and brokers to rethink the stock’s worth, therefore, driving the price lower.

A short seller will open a short position equal to the number of shares he already owns. This allows him to “lock in” today's stock price for the shares he owns. When you think about it, hedging and the ability to lock in a rate are very common in mortgages, commodities, currencies, and a variety of other financial products.

Risks To Consider Before Starting

Besides the usual risk of investing, there are some potential issues with short selling that you must taking into account:

  • Unlimited Potential Losses, Limited Gains

There is one distinction between buying long and selling short that makes short selling a much riskier practice – the level of risk involved when selling short.

When you buy a stock, your total maximum risk is limited to the value of the stock. If X stock is selling for $100 per share, you can only lose $100 per share on your investment – the absolute worst-case scenario is that X stock falls to $0. Because the stock's price will not fall to a negative number, the risk level is limited by the downside boundary of $0.

There is no corresponding upside boundary when selling short. The stock's price can theoretically rise indefinitely higher, and thus the risk is theoretically infinite.

When you sell Y stock short, your risk is not limited to $100 per share. Its share price could rise to $600, $1,000, or even $2,000. You were paid $10,000 for selling 100 shares of Y short ($100 for each multiple by 100). However, if Y rises to $600 per share, repurchasing 100 shares to pay your broker will cost you $60,000 which is  $50,000 more than the $10,000 you received when you sold short.

In practice, you can limit your risk by placing a stop-loss order – an order to close out your market position if your loss reaches a certain amount. If you bought X stock at $100 a share, you'd probably close out your position before it fell to $0 – if you sold Y short, you'd probably close out your position before it rose to $500 a share.

  • Margin Call Risk

If you're going to do a short sale, you'll need a margin account with a broker, which means you'll have to follow the terms of your margin agreement.

One of the rules requires that you maintain the minimum maintenance margin; otherwise, they will send you a margin call to bring the value of your account up to the limit. Most brokers require only a 35 percent margin, but if the stocks involved are too volatile, some brokers will raise it to 70 percent.

Market fluctuations may reduce the value of your account, necessitating the transmission of a margin call. A margin call will necessitate the addition of additional funds to your account.

If you fail to provide additional funds, the broker may take corrective action in accordance with your agreement. He could sell securities in your account or make a buy-in without informing you – even if it means losing money.

  • Changes in Interest Rates

Most investors borrow money to short a stock, and if the interest rate on these loans unexpectedly and significantly rises, the investor may incur a loss.

Rates fluctuate on a daily basis due to factors such as share availability. It's even possible that the rate will change from morning to night. As a result, any increase in interest rates will have an impact on the profit or loss of an investor's short sale transaction.

How to Find Short Selling Stocks 

There are several strategies that you can employ to find a stock to short sell. Generally, these strategies involve setting complex trade parameters to test for specific conditions to exploit. The three most popular short-selling strategies include the Death cross and RSI, Strong overbought conditions, and strong resistance or breaking below support.

You can use the death cross and RSI strategy to identify a bearish momentum. It involves watching for the crossing of the 50-day average below the 200-day moving average. Then you combine it with a low RSI that points to downward momentum.

The next strategy involves looking for conditions that satisfy a strong overbought in a bullish market. These are periods that have sustained a more extended uptrend momentum. Technically, the hunch is that the trend will eventually reverse and become bearish.

The last strategy involves scanning for conditions that satisfy a stock that struggles to break a moving average or break slightly below the support. Typically, to fully have the strategic advantage, you must have technical evaluation skills supported by an understanding of the market sentiments.

Short Selling vs Puts: What's The Difference?

Short selling and puts are both bearish strategies that investors use to speculate on a decline in the price of the underlying security. Both help investors hedge downside risk in a specific stock or portfolio. When using short-selling, investors sell assets that they do not hold in their portfolio in the belief that the underlying asset will decline in value.

In contrast, investors who buy put options bet that the value of the underlying asset will decline in value in the future, and state a price and period in which to sell the asset. The put must be exercised within the period specified in the contract. If the stock price falls below the put strike price, the value of the put option will increase. On the downside, if the stock price rises above the strike price, the put option will be worthless.

How Do You Sell a Stock You Don’t Possess?

You already know the short answer to this question: you have to borrow these stocks from someone who’s willing to do so. The process is actually not so difficult. Once an investor agrees to lend you their stocks, they will relocate their shares to your account. But why would anyone agree to do that?

It’s all about business. If you are trustworthy, an investor will lend you their shares because you will pay them interest on the “loan”.

Number of Short Positions As an Indicator

Knowing is essential and you have to be ready to check out info on stocks and short-selling positions every day if you want to make it big. Where can you find this? The simplest way to do it is to use a reliable source of information – Yahoo Finance. Choose a stock and under the “Share Statistics” section you can find the following info:

  • The number of shorted shares – it shows the number of the shares which were shorted and should be the same as the number on Nasdaq.
  • Short ratio – we also call this ratio “days to cover” and we calculate it by dividing the number shorted shares by the average trading volume.
  • Short positions related to the float – this indicator is a percentage, and it shows how the number of shorted shares relates to the float. The float is the actual number of stocks which investors can trade. This indicator is very important. If this indicator shows 100%, it means that all the stocks belonging to a company have been sold.
  • Number of shorted shares in the previous month

What is a Short Squeeze?

Simply said, this is a situation in which a short seller would never want to be. Sometimes, due to various reasons and factors, a stock’s price starts rising. As you already know, this is very bad news for short sellers. They, of course, start closing their short positions hoping to mitigate losses.

By doing so, they add up extra pressure and the price goes ever so higher. This is what we call a short squeeze. Overall, this is one of the main risks associated with short selling.

Can Short Sellers Manipulate the Market?

This is a question that has many answers. Yes, no, a little bit. Of course, many companies and investors claim that short sellers actually manipulate the market so that they can make huge profits. But isn’t that the market itself? Anyone is trying to “manipulate” something so that they can earn more.

All countries have laws and authorities which determine what is legal and what illegal. They will be after anyone who violates the rules, whether it’s a normal investor, a short seller or a big player like Tesla.

Short selling is for experienced traders.

There are two main types of accounts: cash and margin accounts. The former are accounts where the broker wants the investor to pay for the securities. The latter are accounts in which the broker lends the securities to the borrower. Having said that, if you want to short sell you need to have a margin account. Cash accounts do not allow their owners to short sell.

We’d recommend everyone who wants to become a trader first to open a demo cash account and get to know the basics of day trading. If you are a rookie and jump into the deep waters of short selling, it’s possible that you will lose a lot of money since the potential for that is limitless. Definitely, short selling is for experienced pros who know the ups and downs of this process.

Best Tips For a Successful Short Selling

Here are some tips to consider before starting:

  • Master The Rules

Opening a short or long trading position on an online trading platform usually necessitates the same, traditional steps from a trader. However, the process underlying this strategy is very different. As a result, it is critical to understand how these trades operate. Furthermore, due to the increased risk and complexity of these trades, short selling is typically limited to sophisticated investors, day traders, and hedge funds.

Finally, short selling involves borrowing the stock and thus trading on margin. This implies that there will be fees and interest payments, making the process slightly more complicated than standard stock purchases.

  • Understand Why Do You Short a Company

Before investing in any company, it is critical to understand both the company and the industry in which it operates. This is true for any market in which you wish to invest. Before beginning any trading position, conduct basic research.

Short a stock only if you believe it is currently overvalued and will soon correct itself. Ensure that you have the data to back up your belief through technical or fundamental analysis. Technical analysis indicators, which examines charts and historical prices, can help you confirm your belief.

  • Hedge Your Portfolio

Hedging is one of the best ways to incorporate short selling into your overall trading strategy because it reduces the risk of any position you take by also opening the opposite position.

If you are a trader who prefers to invest in companies through traditional portfolios, make sure to short these companies in case of a short-term price drop. This way, you can profit from bullish trends using traditional financial products while also profiting when companies lose ground in the short term.

  • Use Stop Loss

When you short a stock, your potential loss is infinite because there is no limit to how high the stock can rise.

These order types will assist you in reducing your risk and cutting your losses before they become too large.

  • Leverage Bear Market

Many traders appear to break this rule, only to pay a price for it. Bear markets occur from time to time, but the market is generally on an upward trend. Shorting in a strong bull market is like swimming against the tide, and you have to be extremely lucky to keep your profits intact.

What are The Alternatives to Short Selling?

Maybe short selling is not the thing for you? Are there any other ways an investor can benefit from the falling prices of a stock? Let’s look at some of the alternatives to shorting:

  1.    Stock Futures

Stock futures are futures contracts and work in a similar fashion. A future is a contract between a buyer and a seller in which one of them should buy or sell an asset at a predetermined price at a specific moment in the future. These financial instruments are usually used by experienced traders.

  2.   Put options

As previously mentioned, put options, just like futures, are contracts between a buyer and a seller in which you can sell the shares at a preliminary agreed priced at a specified time. This is not obligatory, only if the seller wants to do so. All you need to pay is a premium. If the price of the stock is below the agreed price on the day the contract expires, you can make a good profit. If it is higher, then you will lose only the premium.

  3.   Inverse ETFs

These are exchange-traded funds which track a sector index in reverse. If the underlying index goes down, the ETF will go in the opposite direction – up. Here you don’t trade on margin. ETFs track whole sectors through the respective index, which means that you cannot trade single stocks.

Bottom Line

All in all, short selling is a great financial tool. I’d recommend it to people who have advanced knowledge of the market as well as experience in trading. This will not only guarantee successful and profitable trading but also help you mitigate the potential losses (which are unlimited).

If you want to capitalize on falling prices and you don’t feel like short selling is your game, you can always try other things, such as inverse ETFs, put options and futures. 

FAQs

To start borrowing shares for short selling, you must have a margin account with a deposit in it.

Contact your broker with the idea of the stocks you think the prevailing prices are way too high than what they will be soon. The broker, in return, finds an investor who is willing to lend the shares. You both agree on the return date and other fees.

Next, take the stock and sell them at the current market price. Then, wait for the stock to fall and buy them at a lower price so that you can return them to the lender. 

Typically, short-selling incentivizes investors to sell more of their stocks. Short selling works involves buying stocks at the current market price with the anticipation it will fall to cash in the price difference between selling and buying.

If selling action tips more sellers to join the trade, especially those trading on the bull market, they will rush to cash in before the market tanks even further to prevent losses. With this trend, the more the sellers, the further the prices sink. 

What are the ideal Conditions for Short Selling?

The best condition to short sell depends on the strategy you will employ. Generally, there is more than one strategy to pull the tide to your side.

One of the strategies advocates steering away from large clouds. Sharp uptrends or deep downtrends may lead to excruciating pains. In the case of strong versus weak sectors, always go with the weak. Capitalize with counter-trend bounds to short.

When there is a big bang of news, be watchful as the crowd is also watching out. A more versatile strategy involves protecting your breakdowns by putting a stop-loss, especially when they fail to meet your