Charting University » Short Selling
Short selling (or "selling short") is a technique used by traders who's goal is to profit from the falling price of a stock, index, or future contract. Yes, you can do that! In fact, there are short funds set up that target these moves. However, since the stock market historically has risen in value over time, short selling is a true skill that requires precise market timing.
The term has a few other names such as: "shorting", "going short" or simply "short a stock". Going short is the opposite to going long - which is the normal expectation of buying low and selling high to gain a profit. Shorting a security is a bearish stance and having a "long view" means to have a bullish view.
How short selling works:
Let's assume that you have charted a stock and it is breaking down from a critical support area. This may be caused by poor earnings, negative news, or simply because the sector that it trades in is under pressure. Short selling is how profits are made - as price moves downward.
As an example, let's say 100 shares is what you want to work with on your 'short'. When you place the short order your broker actually will borrow the shares from someone who owns them with the promise that you will return them later. Your order is filled and you are now 'short the stock'.
It is important to know that since you have to 'borrow' these shares, they are not always available to short from your broker. Ask your broker for a list of 'shortable stocks'.
When the price of the shares drop (if all goes well), you "cover your short position" by buying back the shares, and your broker returns them to the lender. Your profit is then the difference between the price at which you sold the stock (shorted) and your cost to buy it back (covered), minus commissions and expenses for borrowing the stock.
When bad things happen
Here's where shorting can hurt you. If the price of the shares increase, your potential losses are unlimited. The company's shares may go up and up, but at some point you have to replace the 100 shares you sold. In that case, your losses can mount without limit until you cover your short position. Just think if you would have shorted Microsoft or Dell many years ago and let the trade run unchecked. Protection is provided by the use of stop-loss orders that I cover in another section.
When good things happen
The tactic of shorting can be very profitable when trading the S&P E-mini futures, DIA, QQQQ, SDS, or any number of the ETF stocks now available. This is because some traders are better at identifying overpriced or overbought areas on charts or through their analysis of companies.
Analysts tend to focus on what to buy, not what to sell. You will clearly notice this if you watch CNBC or Bloomberg with any regularity. Good news is on every news wire and mentioned every hour on our television financial channels. Bad news is generally, but not always, hidden or spoken about much less. This is because most media, brokers, and analysts want the markets to go higher! Let's face it, most investors do too.
A Short Squeeze is something feared by traders holding a short position. The 'squeeze' occurs when a short position begins to climb higher as buyers step in demanding shares. As short sellers are forced to buy to cover their losses, the price continues to rise, triggering more short sellers to cover their losses. This can become like a rolling snowball that keeps getting bigger. As I mentioned above, traders who practice smart trade management - use stop-losses to protect themselves from large losses. As long as this is done, losses can usually be kept to a limit whether long or short in a trade.
Plays especially at risk in the practice of shorting are smaller, illiquid companies. The danger is that even if the stock is overpriced, it may become even more overpriced, and you will have to buy it at some point to cover your position. Always remember, "it doesn't have to make sense - it just happens".
When you sell short, you're not just betting on what the stock is worth, you're betting on what the market will be willing to pay for the stock in the future.
Holding shorts overnight can open your eyes in the morning. Shorting stocks demands that you know the stock, and know it well if you hold a position overnight or longer. Many unfortunate short traders have woken up only to find that another company has acquired the company they were holding short. This may occur at a significant premium, which would drive up the share price significantly. This has happened quite frequently in the tech sectors with smaller companies that have a good niche product and are gobbled up by a major competitor. This is usually seen by a significant gap in price at the opening bell.
Reason's that good short-traders look for to enter a trade:
- Negative earnings; bad balance sheet or negative cash flows
- Negative news; directly or indirectly related
- Negative news in the stock's sector
- New competition is expected
- Product or service problems announced
- P/E ratios that are much higher than can be justified by growth rates
- The latest fad or sector rally that they are in has peaked; high school kid's likes/dislikes tend to be very obvious to this.
General Stipulations
- You must have a margin account to short stocks.
- The short squeeze can create a situation where your broker must return your borrowed shares to the owner. This does not ocurr often, however if it does, you will be forced to buy back the shares regardless of price.
- You cannot short stocks in a retirement account.
- Short sellers are responsible for paying any dividends that are issued.
- Unlike buying a Long position, your broker must have the stock available in their inventory, or you cannot trade it short.