Short selling can be an attractive strategy to profit from during market downturns – however not without some risk attached.
So, What Is Short Selling?
What does shorting a stock mean?
Well, in times of market turmoil, there are still opportunities to generate returns from stocks. The process is called short selling (or shorting shares of stock, or selling short) and should never be more than part of an overall investment strategy. In its simplest form, short selling is selling shares that you don't own. A stockbroker will first loan you shares that you can sell. When you sell short and borrow shares, think of it as having a loan of shares that you must return at sometime in the future. Short selling is riskier because there is no limit to your losses (stocks can keep rising) as opposed to when purchasing stocks, your losses are limited to your initial investment (if the stock goes to zero).
Short Selling Example
The best way to understand short selling stocks is by looking at a concrete example of short selling explained.
Suppose you do some research and think that LUV's (Southwest Airlines) traffic is falling and the price of oil is skyrocketing and you believe it will continue to do so for at least the short-term. You place an order to sell short 100 shares of LUV and you get filled at $10. Your broker will borrow the shares, and sell these shares for you. Your cash balance will go up by $1,000 and your market value of your stock will now go down by $1,000 (you now owe the broker 100 shares of LUV). If you're correct – and the price of LUV starts to drop – you can then purchase that number of shares at a lower price and replace those that you “borrowed.” This is called “covering your short” and you will pocket a decent profit on the short sale. However, should you be wrong and the price of LUV increases, you may be less than pleased with this strategy as you will have to go out and buy the LUV shares at a higher price such as $12 and now you have lost the difference in prices or $200.
How To Short Sell: 10 Tips To Get You Started
Proceed With Caution
This cannot be stressed enough when it comes to shorting shares of stock. When you short a stock, the potential loss is infinite as there is technically no limit to how high the stock can climb.
Use Stop Orders
These order types will help you minimize your risk and cut your losses before they get out of hand.
Understand How to Use Margin
The process of short selling a stock involves borrowing the stock and therefore trading on margin. This means there are fees and interest payments involved, making the process slightly more complicated than regular stock purchases.
Shorting shares of stock is best used as a tool for hedging
If used properly, short selling can be a great tool to hedge your position. This means to protect yourself against losses on other long (bought) positions.
Wait till you become an advanced trader with more experience
Due to the higher risk and increased complexity of these trades, short selling is usually limited to sophisticated investors, day traders, and hedge funds.
Forget about the high stock price
Don't short simply because the stock has an expensive share price and you think it must come down. Look at evaluation metrics and fundamentals that point to signs that the stock price is inflated and will reverse trend.
Don't ignore the industry as a whole
The stock you choose to short should be part of a struggling industry as well. You want the market, industry, and stock to all show weakness. If any of the three are strong, you increase your chances of picking a loser.
Short in bear or weak markets
Although easier said than done, you can spot bear markets by following the market as a whole. It is in these markets when stocks are struggling to show any green, that there is profit to be made on the downfall.
Look at sales and profit
This applies for both short selling and long investing. Increasing/decreasing sales and profits provide a great indication to the future direction of the stock.
Don't get greedy!!
Set a predetermined exit point. When you hit it, sell! No questions asked.
THE 3 BEST TOOLS FOR BEGINNER INVESTORS
Updated November 6, 2021: At WallStreetSurvivor, our passion is helping you learn to invest in the stock market the RIGHT WAY! As part of our commitment to you, we are constantly evaluating all types of financial tools from stock picking newsletters to brokerage apps to stock screeners and more. Here are our favorites:
1. BEST SOURCE OF STOCK PICKS FOR THE LAST 5 YEARS
We have been tracking ALL of the Motley Fool stock picks since January 2016. That's over 5 years and 120 stock picks. Take a look at their stock picks' performance for the last 5 years:
- Average return of their 120 picks from 2016 to 2020 is 233%
- That beats the SP500's 88%
- 84% of their picks are up
- 57 of those 120 stocks have doubled
Now, no one can guarantee that their next picks will be as strong, but our 5 years of experience has been super profitable as you can see. They do pick some losers, but the key for investors is to invest equal dollar amounts in all of their picks. So if you have $1,000 to invest in the market each month, buy $500 of each of their 2 monthly stock picks.
Normally the Motley Fool service is $199 per year but they are currently offering it at their lowest price ever: Just $79 for 12 months..
2. BEST STOCK BROKERAGE ACCOUNT
Robinhood was the first brokerage site to NOT charge commissions when they opened in 2013. They just past 10,000,000 accounts and to celebrate they are offering one free share of stock (value up to $250) when you open a new account. In addition, they will give you another free share of stock (up to $250) for each friend that you refer, max 3 friends a year.
Here's the details: You must click on a special promo link to open your new Robinhood account. Then when you fund your account with at least $10, you will receive one stock valued between $5 and $250. Then, you will get a link to share with your friends. Every time one of your friends opens an account, you will receive another free stock valued between $5 and $250.
3. FIVE STOCKS LIKELY TO DOUBLE
ZACKS Investment Research just released their list of 5 Stocks Likely to Double. ZACKS has been around since 1978 and their top rated stocks have an average gain of 25.35% per year over the last 30+ years. Best of all, you can get this list of 5 stocks for FREE by CLICKING HERE.