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If you’re serious about making money in the stock market, you need to understand shorting stock.
Well, the market doesn’t always go higher. In fact, the stock market goes higher only about 50% of the time.
Instead of waiting it out or losing money when the stock market goes lower, shorting stock allows you to take advantage of this opportunity.
This gives you the flexibility to profit in any market condition.
In today’s guide, you’re going to learn everything you need to know about shorting stock.
You may have head of hedge funds, speculators, or retail investors “short stock”. Shorting stock is a technique used to take advantage of price falls in any stock.
So what does this mean?
Shorting stock, or short selling, is the sale of shares of stock that the seller currently does not own.
How can you sell something without owning it in the first place?
To sell these shares, short sellers borrow these shares on loan from a broker or other markets makers who have stock in inventory.
In fact, a prerequisite to shorting stock is having stock to borrow from a third party.
Typically most liquid stocks have shares to borrow, making shorting stock easily executed.
However, there are some stocks where it is either hard to borrow or there is none to borrow. This means that the broker or market maker does not have access to shares for you to borrow. In case of a hard to borrow or none to borrow stock, you cannot short stock.
Once your stock broker provides you shares, you can immediately sell the shares in the stock market for the current market price.
After selling the shares, you receive cash upfront for the sale.
But don’t get too excited because that upfront cash is not all yours until you close out the position.
Since you borrowed shares from your broker, you have to return the shares back at some point in the future.
To do so, you have to go into the open market an purchase shares at the current market price, which then you can return the shares back to your broker.
Because you are borrowing money in a short sell, you cannot short stock in an IRA account.
Instead, you can use stock replacement strategies to simulate shorting stock in an IRA account using options strategies.
The main reason an investor would short stock would be because they believe that the stock price will go lower in the future.
If they are correct on their assumption, then they’ll make money as the stock price drops.
Here are two types of investors that might want to short stock: hedgers and speculators.
Hedgers are typically professional investors.
Professional investors typically have billions of dollars tied up in stocks at any point in time.
Having such large stakes in a stock makes it very difficult to quickly liquidate their positions without influencing the price of the underlying stock.
Instead, these savvy investors resort to shorting stock to reduce risk and protect against any downturns in the market.
By taking a short position in a stock, they reduce their overall risk exposure, hedging their existing stock position.
The other type of short seller is the speculator.
A speculator is someone who makes a bet on the future stock price.
To take on this bet, the speculator could use any number of strategies or techniques to base their decision.
This could include anything from fundamental analysis or technical analysis or some other form of market indicator.
The goal of a short sell is to take advantage of a price drop in the underlying stock price.
By selling the shares today at a higher price, the hope is the eventually buy the shares back from the market at a lower price in the future.
After buying the shares back, the investor can return the borrowed shares to the lender, making all parties whole.
Your profit on the trade is the difference in price between what you sold the shares and bought the shares.
So if you short sell the stock for a higher price than what you later buy it back for, you make a profit.
However, if you short sell for a lower price than what you later buy it back for, you produce a loss.
This sounds great and all but here’s the downside:
Shorting stock is theoretically more risky than buying stock.
This is because when you are short shares, you theoretically have unlimited risk because the stock price can go to infinity.
There is no cap on how high the stock price can go.
However, when buying stock, your risk is limited to your total investment if the price of the shares drop to zero.
There is also additional costs to shorting stock.
For instance, the brokerage firm may charge interest on the borrowed stock. Also, if the company pays dividends, you will owe the dividend payment out of your pocket.
Here’s a short selling example.
Let’s say you think that XYZ stock might significantly fall in the near future so you decide that you want to short shares of XYZ stock.
You go to your broker and borrow 100 shares of XYZ stock and immediately sell the shares in the open market for $100 per share so you collect $10,000 upfront for the sale.
However, you now have an obligation to return the 100 shares of XYZ stock to your broker at some point in the future.
You profit if the stock price falls.
So let’s say the stock price falls to $75 per share. You can now exit your position for a profit by buying 100 shares from the open market at $75.
So you pay out $7,500 to purchase the shares and rightfully return the shares that you borrowed back to the broker.
This nets you a profit of $25 per share on the short sell or $2,500 in total profit.
However, if the stock price rises above $100, you lose money.
So now let’s say the stock price rises to $125 per share. You now have a loss of $25 per share because you now have to purchase shares at a higher price than what you initially sold them for, resulting in a loss.
If you close out your position, you pay $125 per share to purchase 100 shares or $12,500 in total.
The resulting loss is $25 per share or $2,500.
Shorting stock may sound like a great tool to add to your toolbox so you can profit when stocks go lower.
But here’s the thing:
Shorting stock can have significant risks due to the potential for unlimited losses.
Due to this heightened risk, there is a phenomena called a short squeeze.
So what is a short squeeze?
A short squeeze refers to a rapid increase in the price of a stock.
This phenomena occurs in stocks with a large “short interest” or a high percentage of shares sold short relative to the total number shares.
Under the right scenario, all of the short sellers could start to buy back their position all at the same time.
Just like in any market, when there is excess demand for an asset, the price typically skyrockets.
This influx of buying pressure occurs because the short sellers want to liquidate their short position before the price of the stock goes too high or before they start taking on losses.
However, this just ignites a positive feedback loop.
The higher the stock price goes, the more pressure there is for short sellers to cover their position all at the same time, squeezing the investors out of their short positions.
If you are the unlucky one last to the exit, you may end up with large losses.
There are two ways to determine if a stock is at risk for a short squeeze: short interest ratio and short interest.
Short interest ratio is the total number of short shares divided by the stock’s average daily trading volume.
However, short interest is a calculation of the number of short shares relative to the number of total shares outstanding.
There is often a misconception that short sellers are against a company or un-American.
It seems like short sellers are hoping that the economy fails.
This is misconception is formed because short sellers can have dramatic impacts on the price of a stock.
So much, so there have even been bans on short selling certain stocks for a period of time.
However, this idea that short sellers are bad for the markets is far from the truth.
In fact, the stock market needs short sellers to run efficiently. This is because they provide liquidity to the markets.
Remember, the stock market runs on buyers and sellers.
Whenever a stock buyer wants to buy shares, there has to be a seller to sell those shares to the stock buyer.
The short seller helps to play this role in a two party system.
Without short sellers, liquidity would dramatically decrease.
This would make it more difficult to buy shares when you want at a fair price.
Short sellers are a necessary party to have a liquid and efficient stock market.
How does this all relate to shorting options contracts?
Shorting an options contract has similar characteristics are shorting stock, but with a few caveats.
Similar to shorting stock, when you short, or sell an options contract, you want to sell it for a higher price than what you later buy it back for.
You make a profit on the difference between where you initially sell the contract and where you later buy the back the contract.
The goal is to initially sell the contract for a higher price, collecting some options premium upfront. Then later close the trade by buying back the contract for a lower price, netting the difference between the two prices.
What’s different from shorting stock?
In shorting stock, you are actually borrowing shares from your broker, which requires margin.
However, when shorting an options contract, you are not borrowing any contract from a third party.
In fact, when you short an options contract, you simply create a new contract with option buyer.
This type of trade does not involve any borrowing or margin. You simply are just taking one side of the transaction.
Here are some short selling tips to keep in mind before you short stock or options.
1. Don’t short stock in buyout targets
Some companies are just seem ripe for a buyout. These are typically companies in a consolidating industry or are relatively small in size relative to its competitors.
This makes the target company a prime target for a buyout.
Why is the something to aware of when shorting stock?
When a company announces that it is planning on buying out a smaller company, the stock price of the buyout target typically skyrockets to reflect the potential for a buyout.
The thing that you want is for the stock price to jump 20% overnight when you are short stock.
If this were to occur, you would be out 20% in the blink of an eye and there would be nothing you could do about it.
2. Be aware of the current short interest
Short interest is a metric that measures the number of shares sold short relative to the total number of shares outstanding.
A high short interest generally means that the stock has the potential for a short squeeze, which is another even that could easily push the stock price higher by 10%+.
This is due to the large number of short sellers currently in the market.
If any number of them get spooked and start buying back shares to cover their position, it could trigger a short squeeze.
This is not a good situation if you are a short seller.
3. Manage your risk
Here’s your third tip:
You need to manage your risk.
This means risking no more than 5% of your account balance on any one trade.
By risking less than 5% of your account balance on any one trade, you dramatically reduce the risk of wiping out your account on one trade.
Remember: the goal of trading is to open your doors the next day.
You simply cannot be successful if you have a high chance of blowing your account on one trade.
However, shorting stock is unique in that it has the potential for theoretically unlimited losses.
To prevent losses from become too out of hand, you should use stop orders or mental stops to take you out of the position before the losses get too large.
4. Be aware of dividends
As a short seller, you are obligated to pay the dividend if there is a dividend payment while you are short stock.
This is because you are borrowing shares from a third party.
When you borrow shares, you have to repay the third party for the dividend payments they would have received had you now borrowed the shares to sell short.
Some stocks have significantly large dividends upwards of $1.00 to $2.00 per share.
This means that if you are short 100 shares, you could potentially owe $100 to $200 in dividend payments.
This is an extra cost that you want to avoid.
5. Use stock replacements for shorting stock in an IRA account
Tip number 5 revolves around getting short in an IRA account.
You cannot short stock in an IRA account due to federal regulations.
However, there are some alternatives that could result in synthetically the same position.
The first is inverse ETFs.
An inverse ETF is a basket of stocks that inversely tracks the performance of its normal counterpart.
For example, SPY is an ETF that tracks the S&P 500 index. However, SPXU is an inverse ETF that inversely tracks the S&P 500 index.
So when SPY goes up, SPXU goes down.
In an IRA account, you can buy SPXU, which will go higher if the S&P 500 goes down.
The second options alternative involves using options contracts.
Using options contracts, you can buy a deep in the money put option, which will give you a short position in the underlying stock.
The positive side for using a deep in the money to synthetically get short the stock is that the put option has defined risk. You can only lose what you pay in premium for the contract.
6. Don’t get greedy
Here’s the last and most important tip when shorting stock.
Don’t get greedy.
This goes to say for any type of trading strategy or technique.
Whenever you introduce emotions into your trading strategy, you are bound for mistakes and losses.
Understanding when you plan on exiting the position either for a winner or for a loss before you enter into the position will to a lot to keeping your trading mechanical and rules based.
So that’s it for our guide to shorting stock.
We hope you enjoyed it.
Now we’d like to hear your take.
Are you going to implement shorting stock into your own trading portfolio?
Or maybe you have a question from today’s guide.
Either way, let us know by leaving a quick comment below.
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