WHAT IS SHORT SELLING AND HOW DOES IT WORK?
Short selling can be an attractive strategy to profit from during market downturns – however not without some risk attached.
In times of market turmoil, there are still opportunities to generate returns from stocks. The process is called short selling (or shorting) 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 is by looking at a concrete example.
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 stocks. 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 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 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.
Short selling is merely a tool in an investor’s toolbox. It should not be the focus of an investment strategy but complement one. It can provide yield during struggling economies makes it an attractive tactic. However, it is important to understand all the risks involved before diving in. To learn more about short selling, check out our Understanding Advanced Techniques course