Check out this guide to learn what it is, and the best ways to do it.
How to Short a Stock
Short selling a stock is a common investment strategy, but it can also be a bit risky. This practice takes some skill and dedication to manoeuvre, and you should be sure you fully understand the concept before you try it. It’s best to be experienced in trading so you have a clear picture of the concepts and the risks.
That being said, there are many investors who have found themselves to be quite successful with short selling stock. Curious to know more about this strategy? Check out this guide to learn what it is, and the best ways to do it.
What is Shorting a Stock?
Shorting a stock is the act of borrowing against a stock from a low price, in hopes that you can buy it back even lower. Not everyone can short sell a stock. You must have access to margin and borrowing power on your trading platform.
Some platforms do not even allow shorting a stock, and others require you to be an approved investor to do so.
This strategy is really all about speculation. You’re speculating that a stock is going to significantly drop in price. Speculation is considered to be a high-risk strategy, which is why it is imperative you have some experience as an investor before you try it.
Some people will also hedge to provide some extra protection against the downside risk. The process involves borrowing against a stock to sell shares. You then buy the borrowed shares at a low price, or at least that is the idea. When successful, the profit is the difference between the borrowed stock and the price you purchase it at.
Steps to Short a Stock
There are traditional trades, as well as long sales and short sales when it comes to stock. Of course, there are multiple different trading strategies out there to work with, or you can simply purchase stock to hold as well.
Shorting a stock is developed around the thought that you believe a stock is going to decline in price. So, you borrow the stock to sell, and then you buy it back at that low price to cover what you borrowed against. The risk? Well, it could be limitless considering stocks could rise without end.
Remember that in order to short sell stock, you have to be using a qualifying platform.
You also have to be approved to do so in most cases. We mention this so you don’t just assume you can jump in and short sell at any given time.
These are the basic steps to short selling a stock.
- Determine what stock you want to short sell with.
- Borrow against a stock to open the position.
- Pay attention to the prices.
- Buy the stock back, hopefully when the market is at a lower price.
To be clear, you will have to buy the stock back. The question is will the price really go down as you speculated, or you will have to purchase it at a higher price and pay the difference?
These steps will ultimately take you through the process of trading the stock, and will work the same every single time. What changes might be the approach that you use, as well as the outcomes.
There are some different methods of shorting stock as well, so let’s talk about those.
Methods of Shorting Stock
While shorting stock remains the same in theory, there are different approaches to doing so. If you want a more protected position, you might choose to hedge it. Just like there are different overall trading strategies, there are also different strategies to a short sale.
A few of the strategies are explained below.
If you use some sort of leverage when you are short selling the stock, there is a slightly different approach. In most cases, you would use derivatives for this type of strategy.
Derivate trading is speculation, so you aren’t actually borrowing the stock in this case, but still taking ownership for your sell to open the position.
For trading with leverage, you will likely either be trading on a spread, or using CFDs for trading. Spreads put a position on each side to help hedge (or leverage) your strategy against the stock in question.
With CFDs, you’re signing up for a contract. That contract is like an exchange of the stock, and the difference is the opening and closing prices of the market that day on the chosen stock.
Standard Short Selling
You can also short sell in a simple method, which is the standard method. Forget the hedging and leveraging, or trying to figure out the complicated details. Instead, just make the short sell based on your speculation.
This works by borrowing the stock from another shareholder, when you don’t already own the stock. You borrow the stock to make the sale. You then purchase the stock. The idea is that the market will fall and you will be able to purchase the stock at a lower price than you borrowed it for, providing some profit back to you.
Another strategy used for short sales is options trading. This is perhaps one of the more common approaches because it is more familiar, and you can add in control in some ways. To short sell a stock using options, you would buy a put option on the stock. This then gives you the right to sell those shares at a strike price, but doesn’t obligate you to do so.
The thing to remember with options is that you may be using margin to trade, or you may have to already own the stock in question.
Options do have expiration dates, whereas traditional short sales typically do not. This could limit your timeframe to take action, as opposed to a traditional short sell of a stock.
What Will a Shorting a Stock Cost You?
When it comes to short selling stock, there are some costs to be aware of, even outside the realm of the potential cost of the stock itself. There are additional costs that you could be subjected to, depending on the account you hold and the fees that they charge for their services.
These are some of the additional costs that may be involved.
- Cost of margin (interest)
- Any dividends or payments
- Cost of borrowing stock
But what does all this mean?
Margin is basically borrowing power, like a loan, but for the stock market. You’re borrowing funds from your broker in order to make a specific investment. In order to have margin capabilities, you will have to be approved by your broker. The fees associated with using margin are interest costs.
You pay interest on the funds you borrow, just like you would with a loan.
Some stocks have dividends or required payments that come up while you’re in the process of a short sell. Since you borrowed that stock from someone else, you become responsible for making dividend payments to the original owner. You could be responsible for dividends, spinoffs, stock splits, and other costs that happen unexpectedly.
Finally, the cost of borrowing stock will differ from trade to trade. In some cases, stocks are much harder to borrow, and these stocks often have additional fees for short sells. How much the cost is depends on how long the short trade is left open, but this is definitely something to be aware of.
In addition to these things, you might also have to spend money buying back the stock. For example, if this stock rises instead of declines, you’ve still got to buy it at some point. You may be buying it for more money, and taking a loss. This will also cost you money.
What are the Risks of Shorting a Stock?
With shorting a stock, there are inherent risks involved as well. Since this is a speculatory approach to trading, you could be exposed to high levels of risk. The obvious risk is that you could lose a lot of money on the deal from your speculations, but what could provoke these risks?
Here are a few things below.
Marginal Money Risks
When you use margin to short the stock, you are borrowing money to do so. This puts you at risk not only for the stock prices, but also the risk of paying high interest for the use of margin. This could cost you a lot of money if the price were to rise astronomically.
Margin regulations typically require you to have at least 25% cash, so if the prices rise and you’re using margin, you may have to input more money to meet those requirements.
Timing is everything. Remember that short selling stock is considered speculation. Just because you are speculating that a stock will decline, doesn’t mean it actually will.
When a company is overvalued, prices don’t always decline right away.
If you short sell the stock too soon, you could be exposed to fees, interest, and a much longer waiting game. And if you did use margin or calls and puts, then you could be subject to interest, expiration date, and even missing the moment.
Short Squeeze Risks
A short squeeze is a specific term that comes into play when a stock is short and your trade is still in process when you buy it back. The squeeze is when the stock is actively being sold short by multiple holders. Then, when they try to buy it back low, it causes a fluctuation in demand on the stock, pushing the prices up higher.
When there is high demand and prices rise, this could leave you in a vulnerable position.
One of the biggest challenges and risks you might face is dealing with regulations. These are regulated for a reason, and that’s because they are considered high risk. You won’t be able to short sell with some platforms, and will have to be approved to do so with others. These regulations exist as a protective measure, but they could cause roadblocks for you in the process.
If you already short sold, and then regulators enact a ban on short sales for a sector, this could cause buyers to purchase and drive the price upward. The result is you having to buy for higher to cover your short position.
When is a Good Time to Short Sell?
Choosing when to short sell a stock is completely up to your judgment. This speculatory trading approach requires thought, research, and attention to detail. There are many professionals who will not short sell, and then there are many risk takers who enjoy trying to make a profit this way.
If you are considering trying to short sell stocks, consider these times when the market might be more ideal. However, there is still no guarantee, so keep that in mind.
Plummeting Stocks and Markets
The idea behind short sells is that a stock price will decrease, right? So, when you’re noticing a deteriorating market, or even a specific stock, this could be an ideal time to short sell.
Look at the fundamentals of the market, and the stock you’re eyeballing.
You can keep an eye on a business and have some insights as to whether they may be struggling, or whether their values may be going down in the near future. Whether they are seeing declines in revenues and profits, or they are weak in the current market, this might be a sign to you. It might be an opportunity as well if you are paying attention.
Bear markets are often a good time for shorting stocks, because the trend of the market is in your favor. A bear market is by its nature a time when stocks are steadily declining. The official terminology is in place when the market has declined 20% or more based on one of the major indices.
Bear markets are an opportunity to buy, and if you saw the declines in the market coming, you could make a short sell before they happen and profit from doing so.
When people, and the market, get optimistic, it causes values and prices to go up. It’s a lot about supply and demand in these cases. Prices go up and they go down.
It’s a cyclical manoeuvre that happens in the market.
When one sector is seeing a bit of success, the values will elevate because of it. At some point, what goes up must come down. If you’re paying close attention, you can get in on a short sell when the values just start to decrease, and then close the sell at the low.
Short Selling Stock isn’t for Everyone
It’s ultimately up to you to determine whether or not short selling stock is a good approach for you. Before you do, be sure to plug into research, and maybe even do some practice trading to get a feel for what you are monitoring for short sells.
Remember that this type of trading is considered speculation, and it is a high-risk form of trading. Take the time to learn the ins and outs and determine what type of strategy you want to use. Know and understand the risks and costs associated with doing so.
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