If you read the last lesson, you just finished learning about the value of stop-loss orders. Stop-loss orders are an especially valuable tool if you’re planning to pursue the trading strategy we’re going to learn about now: short selling.
An Introduction to Short Selling
When it comes to stock market investing, most of the attention tends to focus on the strategy of “going long,” as in buying a stock and hoping that it goes up in price. The flip side of that approach is short selling (shorting), which is when you bet on a stock to go down in price.
Let’s take a closer look at the key traits of bull markets, and what causes them.
What Is Short Selling (shorting)?
When you sell a stock short, you’re borrowing shares from a broker, then buying them back at lower prices. You make a profit if you short the stock, its price falls after you short it, then you “cover” your position by buying the shares back.
Here’s an example of how short selling works. Say you short-sell a stock at $100 a share, then cover your position when the price drops to $90. If that’s the case, you’ve made a profit of $10 per share, or 10%.
Now let’s look at the flip side. If you short-sell a stock at $100 a share and it rises to $110 a share, you incur a loss of $10 per share, or 10%.
Benefits of Short Selling
The most obvious advantage of short selling is that you can benefit from a stock’s price falling, without needing to actually own the stock.
Short selling also offers a potentially profitable trading strategy during bear markets. Rather than having to sit on the sidelines and wait months or even years for stocks to bounce back, you can instead bet on individual stocks to fall. Most stocks tend to follow the broad market’s trend, so short selling can deliver heady gains during market downturns.
Also, you can use leverage when short selling, in the same way that you can do so when going long on a stock. When you use leverage, you’re putting in just a fraction of the total cost of your trade, and borrowing funds from your broker for the rest. That way if the stock goes down during your short sale, you make more money than you would if you only ventured your own capital.
Risks of Short Selling
The biggest risk when short selling is the threat of losses larger than 100%. For instance, if you buy a stock at $100 a share and it goes to 0$, you lose 100% of your investment. But if you short a stock at $100 a share and it rises to $500, you lose five times the size of your initial investment.
When a stock issues dividends, that can also cost you money, assuming you keep your trade open long enough for those dividends to kick in.
Finally, you should know that when you borrow from a broker, you must maintain a certain equity percentage in your account. If your position falls below that threshold, your broker will force you to put more money in your account. So you need to have cash on hand and be willing to sacrifice some liquidity if you want to sell short.
Top Tips to Succeed at Short Selling
All things being equal, you should try short selling during market downturns and not market up-trends, as individual stocks tend to follow the direction of the broad indexes.
Short selling can sometimes work better as a shorter-term trade than a longer-term trade, for two reasons.
- If you short a stock that issues quarterly dividends, you’ll lose a chunk of your profit once the end of the quarter arrives, because that’s when dividends get doled out.
- Stocks’ natural inclination over time is to rise; hold onto a short position for too long and you could learn that lesson the hard way.
Finally, use stop-loss orders when short selling stocks.
Say you short a stock at $100 per share. If you immediately follow your short-sell trade by setting a stop-loss order at $110 per share, you can rest easy knowing that if the stock hits $110, your broker will automatically close your position, limiting your loss to 10%.
Kudos for learning about short selling today! Short selling might seem counter-intuitive at first, but as you can see, it can be a powerful money-making tool if done right. If you’re ready for the next lesson, click below. If you want to learn more about short selling and other trading techniques, check out our full range of educational articles on this site.