Short-selling involves selling borrowed shares and buying them back at a lower price. We only recommend entering into selling short stocks if you are an experienced stock trader due to the financial risks involved.
In this article we talk about short-selling, the strategy and risks involved, and when is the most profitable time to short stock.
What is Short-Selling?
Learning how to short stocks is a great way to make a profit when market values are decreasing. Short-selling is when investors predict that a stock is more likely to drop in value than to increase.
Shorting stocks involves borrowing shares from your broker and selling them to make a profit. A decline in share prices lets you buy back the shares for a lower price than what you sold them for. The margin difference is the profit that you take away from the trade.
How do you short a stock?
To short stocks as a trading strategy, you need to be well-educated on the stock market and price movements. Here is a step-by-step guide on how to short stocks.
- Set up a margin account with your broker and make sure that you have the necessary allowance to open a short position.
- Choose the stock that you want to sell short.
- Place your short order for the stock through your broker. Your broker will lend you the shares and sell them on the market on your behalf.
- Close out your short position. This is done by buying back the stock that you initially sold and returning the borrowed shares to your broker.
- If your decline in price prediction is true, you will keep the margin difference as profit. If the price of the stock went up, it will cost you more to buy back the shares. This will lead to a loss on your short position.
An example of a short-selling trade
Shares of a company are trading for $50 a share. You predict that this share price is over-valued and that the price will drop. You place a short order with your broker, who lends you 100 shares in the company. You sell these shares on the market and now have $5,000.
A week later, the company reports mismanagement and the value falls to $30 per share. You then buy 100 shares of the company at the new share price for a total of $3,000. You have returned the borrowed shares to your broker, which leaves you a profit of $2,000. This profit is the margin difference between the two prices.
The cost of shorting stocks
Shorting stocks involve extra costs you need to be aware of. Most brokers charge extra fees or interest rates on the borrowed stock. If a stock is difficult to borrow, then the interest rate will increase.
Even though you have borrowed the stock, the dividends still belong to the lender. This becomes a problem for you if a company pays out dividends while you are borrowing shares. You will need to pay out dividends between the time you borrowed and when you returned the stock.
What are the best conditions for shorting stocks?
You generally decide to short a stock after you predict a decline in value. Here are the best conditions in which shorting is most profitable.
During a bear market
A bear market is when the dominant trend for a stock market or industry is down. You have a better chance of making profitable short sale trades during these periods. An entrenched bear market gives better profit than a strong phase.
When stock fundamentals are deteriorating
Stock fundamentals deteriorate for various reasons. Slowing profit growth, increasing challenges to the business, and rising input costs are some examples. These are important things to watch out for when predicting price movements.
Market fundamentals generally worsen due to economic slowdown. These are often due to adverse geopolitical developments or deteriorating market breadth.
Phases of overvaluation due to investor optimism
Sometimes stock is over-valued due to heightened levels of optimism by investors. This may be due to the excitement of new developments in the market or improved sectors of the economy.
This often leads to disappointment when high expectations are not met. Experienced short-sellers use these investment trends to predict price movements and market roll-overs.
Technical indicators confirm bearish trends
There are several technical indicators used to confirm bearish trends. A common indicator is the moving average of a stock. A moving average is the average of a stock's price over a certain period.
If the current price goes either above or below the average, this signals a new trend in price.
Short Selling Metrics
These two metrics help investors to track short-selling activity on stocks:
Short interest ratio (SIR) is the ratio of shorted shares compared to the number of shares available on the market at a given time. This is also known as short float. A high SIR indicates overvalued stocks with falling prices.
Short interest to volume ratio is the total shorted shares divided by the daily average trading volume of the stock. A high ratio indicates decreasing prices for a stock.
What are the risks of shorting a stock?
There are many risks to be aware of when shorting stocks. If you predict the wrong price movement you will lose all your profit. Entering into a trade too early may make it difficult to hold on to the short position. There is always risk of your costs or potential losses increasing while holding a trade.
If a large number of short-sellers try to cover their position on a stock this might lead to a short squeeze. As a result, this will drive up the price even more.
Short squeezes also happen when stock owners move assets from their margin accounts to cash accounts. This reduces the availability of the stock for borrowing.
You aren't in full control of a short trade. Under volatile conditions, your broker may intervene to stabilize market conditions. This might force you to put up more money or to buy in the stock for a higher price.
Conclusion
Shorting stocks is a great way for traders to earn a profit during downward market phases.
There are many financial risks involved to be aware of. You should only enter into a short-selling trade if you are an experienced stock trader.
