Shorting A Stock Or Short Selling Is Speculating That A Stock Price Will Go Down. Understand How This Works & Learn About The Risks Of Shorting
Shorting a stock or short selling is an old and popular strategy for cashing in on market volatility. Essentially, a short or short sale is a bet that a stock’s value will drop soon. However, shorting is both dangerous and complex because short sellers usually rely on margin lending to finance their trading.
In a classic short, a trader agrees to buy a specific amount of stock but does not pay for it for a period. The trader hopes that the share price will fall by the time he has to pay for the stock.
Why Shorting Works
In a typical short, Jane agrees to buy 20 shares of Tesla (NASDAQ: TSLA) that are trading at $300. However, Jane will not pay for shares for two weeks because she thinks Tesla’s share price will drop to $270.
Effectively, Jane could buy the stock at a 30% discount if the shorting works. However, Jane will pay 30% more if Tesla’s share price increases to $330.
Additionally, Jane’s long-term hope is that the price will rise after she buys it at the discount. Obviously, Jane can lose money if she buys Telsa at $270 a share and its price keeps dropping.
Shorting and Margin Trading are Dangerous
Shorting stocks is a very dangerous proposition because most short selling strategies involve margin trading or lending.
In margin trading, the buyer borrows money from a broker or exchange to cover the cost of the trades. To explain, the trader hopes he or she can pay off the loan with the proceeds of the trades.
For instance, Jane could buy Tesla at $270 with a 5% interest margin loan. Then wait until Tesla’s price rises to $300 and sell it. Thus, Jane will make a $30 profit on each share she sells, and be able to pay off the loan with part of the profits.
However, Jane will lose money if Tesla’s price drops because she must repay the margin loan even if the share price drops to $240. Thus, Jane will have to pay the $270 plus the interest.
In consequence, the ultimate risk of margin trading and shorting is not having enough money to repay the margin loans. In investment industry slang they call this blowing up. Blowing up means a trader is not making enough money from his or her trades to pay his or her margin loans.
Shorting a Stock is Speculation
Shorting stocks is not investing, instead shorting is called speculation. To explain, the difference, investing means you expect a return from an investment. For example, a dividend from a stock.
However, in speculation, you hope that your strategy will lead to a return. For example, Jane hopes Tesla’s price will fall and rise again. Thus, in speculation there is no guaranteed return.
Moreover, speculative trading is usually a short-term strategy. Specifically, Jane hopes Tesla’s share price will increase before her margin loans come due.
In fact, the term shorting is finance industry slang for any short-term trade. The expectation being they finance most shorts with margin loans.
How Much Money do you Need to Short Stocks?
Shorting stocks is dangerous because it is easy to run of money while doing it.
Thus, you must never short stocks unless you have enough money or credit to pay for all the stock at the full price available. You will need such reserves because the stock’s price may not fall.
Moreover, you should have enough money to pay for the stock if the price explodes. For instance, if a $100 stock suddenly jumps to $150 in price.
Hence, never short stock unless your reserve, or line of credit, is double the value of the sock you propose to buy. In addition, the amount you short should always be 50% or less than your reserve or line of credit.
Following the 50% rule is a good idea because you will not run out of money. Those who follow the 50% rule will always have something left over.
Place a Stop Loss on Shorts
You can avoid many of the risks of shorting with a stop-loss order. To explain, a stop loss is an amount of money which you will not speculate beyond.
For instance, you can set a stop loss to activate at a specific amount, such as a 25% profit. Hence, you will make money without taking a great risk.
Additionally, you might stop trading if stock prices move too fast. For instance, if a stock price increases by over 25% in a 24-hour period. Thus, you can avoid dangerous market movements.
Finally, have market conditions under which you will not trade. For instance, if the market drops or rises dramatically. Pulling out during major market fluctuations is a good idea because many shorting strategies will not work during rapid market changes.
Who Should Short and When?
Interestingly, deciding when to short is just as important as your strategy. To explain, shorting usually only succeeds under specific market conditions such as sudden market interest in a particular stock.
Hence, watch the markets closely when you short. Thus, you should not short if you do not have the time to pay close attention to the market. In addition, avoid shorting if constantly watching the market or trades bores you.
Only people that get excited by the market and have fun trading should short. Instead, pick a trading strategy that suits your personality.
For instance, a person who hates constantly watching the market will be better off with a buy-and-hold strategy, or an index fund. On the other hand, someone who loves the thrill of the market can make money with shorting.
Finally, only short if you can afford to do so. Notably, only short with extra money will not need to live on. If you are having trouble paying the bills or have no savings do not short.
However, shorting is a great way for a person with a lot of extra cash to make money from the stock market, if you understand it and do it right.
Shorting and Leverage
Leverage means the amount of credit you can receive from a margin account.
Smart traders understand that leverage is a precious commodity and use it sparingly. A good rule of thumb, mentioned above, is to never use over 50% of your leverage.
Thus, getting a margin account that offers leverage is a good idea when you short. One reason to use margin credit for shorting is to avoid spending all your cash.
In fact, many successful short traders never use cash to buy stocks. Instead, they use credit and shorting for their purchases.
Research and Study
Another major mistake many people make with shorting is not to study and understand the stocks they short. For instance, they do not research the companies and the stock’s history.
Not surprisingly, these people often get taken by surprise by unexpected movements and sudden price changes. For example, such traders get caught by surprise when a company brings out a new product or reports a bad quarter.
Therefore, spend a few hours researching the stock and the company behind it before shorting it. During the research, you must pay close attention to any development that could affect the business’s market value.
Examples of such developments include management changes, corporate scandals, new products, supply chain problems, new technologies, labor troubles, and market changes. For instance, you should be leery of companies that manufacture and market complex machines like aircraft or vehicles.
At such businesses, problems with just one part of one model can cause a stock to fall. However, such problems can create shorting opportunities because they can lead to short-term price drops.
Generally, stock prices will rise once investors realize a problem is short-term. However, prices can fall more if the market underestimates a company’s problems.
How to Short Stocks?
Thus, it is often a good idea to only short stocks from companies in industries you understand. For example, the business you work in or a field in which you have a strong interest.
Hence, a good way to short stocks is to concentrate on those businesses you understand best. You can identify these companies by making a list of your interests, knowledge and experience and comparing it to stock listings.
In addition, set aside a specific amount of money to use for shorting and only spend those funds. If you run out of money stop and wait until you get more money.
Most importantly, learn not to overestimate your abilities. Most people fail at shorting because they underestimate market volatility and overestimate their insight and trading abilities.
A good way to avoid blowing up your account when shorting is to always spend one half of what you think you can afford. Thus, you will always have money left over when you short.
Market Timing For Shorting
Finally, always pay careful attention to overall market conditions and be ready to short if they are bad. For example, shorting can be used if outside events like news of war, terrorism, financial crises, panics, or political changes affects the market. In particular, if you think a market correction is starting, all stocks get pulled down, therefore it is a good time to short. The caveat here is an unpredictable and volatile market going through a correction because price swings and unforeseen variables can wreck your shorting strategy fast in an unstable market.
Shorting stocks can be fun and profitable if you do it wisely. Thus, you should only short stocks if you have a good understanding of the market and the discipline to follow a strategy. If you lack those attributes shorting is not for you.