Shorting a stock is one of a trader’s basic tools…
For a basic tool, though, there’s a lot of confusion around it. Selling shares you don’t own, profiting when they sink in price … huh?
If you follow me, I have to apologize … I like to hate on shorts:
Let me be clear: short selling isn’t a bad thing, and it’s not all that complicated … But you must know how to do it correctly.
Sure, there are added risks and costs with shorting, but in the right situations, it can be a heck of an exciting ride.
As always, research and finding the best opportunities are key.
There’s no doubt that many of the best traders short sell shares as a part of their trading strategy. So is short selling worth it? Let’s find out.
And stick around to the end for a great infographic on short selling. It’s a great visual guide to help you navigate this strategy.
Table of Contents
- 1 What Is Shorting a Stock?
- 2 How to Make Money Short Selling
- 3 The Risks of Short Selling
- 4 Why Should You Short Sell?
- 5 Shorting Stocks: Pros and Cons
- 6 What Are the Costs of Shorting a Stock?
- 7 Short Selling Metrics
- 8 What Are the Ideal Conditions to Short a Stock?
- 9 What’s Next?
- 10 The Bottom Line
- 11 One Platform. One System. Every Tool
What Is Shorting a Stock?
What does shorting a stock mean?
Shorting a stock is when you open a position by borrowing shares you don’t own to sell to another trader…
What you’re hoping for here is for the stock price to go down…
Then, you’d close your short position by buying the stock at a lower price and returning your borrowed shares.
Why is it called shorting a stock?
The internet has a lot of ideas on this. Most come down to a connection between the word ‘short’ and ‘less’ … But who knows.
The point is, there’s a lot of misinformation about short selling out there.
Traders ask me, “why is short selling bad?” on a regular basis. I’ve even been asked, “Is short selling penny stocks illegal?”
When used correctly, short selling is a valuable part of a trader’s arsenal. It’s one way to actively trade a bearish trend.
It also helps the market by adding liquidity when demand for a stock is low.
Every trader should know how shorting a stock works … they should also understand its risks.
I’ll get to those later, but here’s the big one: your losses are theoretically infinite.
Shorting a Stock: Examples
When you buy a stock — or go long — you can only lose the amount you put in. If the stock costs $10 and you buy 10 shares, you can only lose $100.
But let’s say you short that same stock … It’s up big on some bogus news, and you think it’s had its run…
The company sees the gains its shares are making. But the company doesn’t actually profit from these gains. Unless…
It issues newly created shares and does a secondary offering to cash in. So the float used to be 20 million and now it’s 23 million.
This is the perfect time to short, right? The stock’s gotta come down … Doesn’t it?
Well, maybe. Or maybe people on Reddit are talking about it and decide to HODL. Maybe it’s got another Twitter pump coming.
Shorting a penny stock has always carried risks … But shorting a stock in the Robinhood age has its own set of risks.
That’s the thing about short selling. The stock might be doomed, and you might be right.
But you’re on the clock. Your broker can close your short position at any time. Redditors might see a big short float and try to squeeze you out.
With short selling, we’re flipping the age-old warning of caveat emptor. Here, it’s ‘seller beware.’
How to Make Money Short Selling
You make money short selling the same way you make money going long … Buy low and sell high. Just flip the order. Here it is, step by step:
- Open a margin account. You’ll need to be able to borrow shares if you want to short them. To do that, you need to set up a margin account.
- Identify the stock. What makes a good shorting candidate is up to your trading style. Just make sure whatever you short fits your trading criteria.
- Short sell the shares. How do you borrow a stock? Just place a short order … Your broker will take care of the rest! The only difference in how to short a stock on E-Trade or Robinhood is share availability. Some brokers are better at locating shares to borrow than others. You’ll figure out if your broker fits your trading style by trial and error. And always remember to use a limit order, so you get an entry that fits your trading plan.
- Wait for the stock to fall. When you’re in a good position, good trading is about sitting on your hands. Wait for the stock you shorted to make the down move you anticipated. Unless it hits your risk limit first! More on that later…
- Buy back the shares. When you reach your goal, close your position.
- Pat yourself on the back. If you stuck to your trading plan, congratulate yourself on a job well done!
The Risks of Short Selling
Here’s my favorite part — the risks.
If you’re a regular reader of the StocksToTrade blog, you know to pay attention to risk. Just like a fence is only as strong as its weakest link, a trading plan is only as good as its risk.
No one wants to lose their trades. But planning for the worst is what trading is all about.
You need to know the risks of shorting before you try it out. If you don’t, your risk level ratchets all the way up to blowing up your account!
That’s the number-one thing you’re trying to prevent as a trader.
Read on for the highlights.
- Buy-in. Your broker may close your position at any time. That’s when they liquidate your position, taking money out of your account to pay back your losses. Make sure you consider a buy-in when you analyze risk.
- The short squeeze. Stocks that are heavily shorted can be a target of short squeezes. This is where the stock rises heavily in price, and short sellers rush to exit their positions. This buying frenzy will push the price up further.
Why Should You Short Sell?
OK — you know the downside.
Short selling wouldn’t be a thing if there were no potential upside.
How does short selling a stock work? Short-biased traders may use it for one of these reasons:
- To hedge downside risk. Say, for example, you’re holding a bunch of stocks long, and you’re happy with the trades. But what if the market tanks a couple of percentage points overnight? If you hold a few shorts and a few longs in various stocks, you might be able to hedge the downside risk. Short profits could make up for the losses on the longs.
- You’re good at finding companies headed down in price. Even in a bull market environment, crappy stocks often fall. If you’re good at spotting this, developing the ability to play the short side could be just what you’re looking for.
- To be a well-rounded trader. You can be a one-trick pony and only hold stocks long. But if you want to take advantage of all the opportunities the market has to offer, develop your shorting skills and knowledge.
Shorting Stocks: Pros and Cons
It’s easy to give a definition of shorting a stock…
It’s a bit harder to understand the pros and cons of shorting in real time.
One of the best ways to learn new trading techniques is to take part in a community. This way, you won’t only learn from your mistakes…
You also have the chance to learn from the mistakes of others.
The trading community that I lead is called the SteadyTrade Team.
If you like what you’ve seen on my YouTube channel, well … That’s just the tip of the iceberg.
The SteadyTrade Team is an inclusive mentorship service. Top trader Mike “Huddie” Hudson and I go in-depth on our strategy and market thoughts every trading day of the year!
We support traders with the techniques and mindset tips that have worked for us. We’ve designed a trading community that supports education and is kind of fun, too!
When you join us, you get:
- Twice-daily webinars. Every trading day begins and ends with my read on the day’s moves. I’ll answer questions, consult on trading plans, and share my ideas on stock charts. This is the hands-on training that can help you improve.
- Weekly strategy sessions. Trading isn’t about catching the latest moves … it’s about understanding the ‘why’ of these moves. Every week, we break down an essential piece of market strategy.
- An insanely collaborative chat room. Our chat room isn’t full of pumpers … It’s a place for new and experienced traders alike to compare notes.
- A whole archive you can explore. If you’re hungry, we’ve got more.
What Are the Costs of Shorting a Stock?
There are a few fees associated with shorting … and you need to account for them in your trading plan.
Stock borrowing costs are the one thing you can’t easily predict. Pay close attention…
Stock Borrowing Costs
Some stocks are hard to borrow for shorting. With hard-to-borrow status comes higher fees. Make sure you factor fees into your risk/reward analysis before you make the trade.
Even after you pay any initial borrowing costs, you can’t just borrow the stock for free. You have to pay margin interest.
The interest you pay can definitely add up over time … especially if you hold a stock short for a while.
Dividends and Other Payments
This is where your research comes in. You want to control everything you can in the market…
These costs shouldn’t come as a surprise. But they can be significant.
You’ll have to pay the stock ‘owner’ the value of any dividend. Make sure you check the company’s dividend schedule.
Other payments are also on you. Let’s say the stock you’ve shorted has a share split. You’ll have to pay the original stockholder whatever they would have profited from the event.
Just make sure you do your homework before starting with your short sales!
Short Selling Metrics
Short squeezes have been trending among the Reddit crowd…
It’s important to know what you’re getting into when you’re shorting. One metric a lot of traders have been taking aim at is high short interest…
This is the amount of the float being held short at last count. These traders, like you, are betting that the stock price will soon fall.
But what if it goes up? These traders will run for the doors…
At least that’s how the theory goes. I think the importance of short interest is overblown. It’s not the same as the GameStop situation back in January. No one is shorting 100% of the float.
But shorts have a habit of getting cocky nonetheless, so be prepared.
Fintwit short sellers when they cover for a 125% loss after being down 400%+ pic.twitter.com/TW0NMeJpv8— Timothy C. Bohen (@tbohen) March 24, 2021
I haven’t invented anything here. The word is out. It’s open season on shorts…
The biggest risk in shorting has gone mainstream.
What Are the Ideal Conditions to Short a Stock?
Let’s break it down a bit more.
The dangers of shorting are like the dangers of going long. They’re often tied to mindset … and stubborn beliefs that won’t change.
The right time to short is when the environment is right for it. Which comes down to the following criteria…
During a Bear Market
When the stock market is headed downward, we often see the bulk of stocks making down price moves. You may find smart trades more easily by looking for short-selling opportunities.
When the Fundamentals Are Deteriorating
This one matters, but not as much as you may think…
GameStop Corp. (NYSE: GME) was heavily shorted because it has a bad business model. The world of entertainment has changed, and the company hasn’t adapted. Unless it changes what it’s doing now, it’s basically doomed.
Do you think that matters to the WallStreetBets crowd? They don’t care if these companies are around in five years…
Heck, they’ll run up the price of bankrupt companies like Hertz and Blockbuster Video! In the meantime, shorts continue to get blown out of the water.
When Technical Indicators Confirm Bearish Trends
There are as many trading approaches as there are traders.
To short sell, you don’t need to have any grand ideas about where the stock price is going…
You just have to identify a bearish trend and match its timing with your trade.
You can trade the first red day pattern. This is a specialty of StocksToTrade’s Breakouts & Breakdowns alerts service moderators…
Here’s Jack and Kyle in action on the TWIST podcast:
But make sure you’re using a trading journal … That’s the best way to learn what works for you.
When There Are Elevated Levels Amid Rampant Optimism
Warren Buffett is a notorious anti-shorter…
But he still gave this all-time shorting advice: “Be fearful when others are greedy, and greedy when others are fearful.”
When people think a stock can’t fail — watch out.
You need a trading edge if you want to last in the market.
No, I’m not talking about ‘short selling for dummies’ … I’m talking about a premium trading platform that can help make your life easier!
That platform, to me, is StocksToTrade. It was built by a group of active traders who wanted to cut some of the stress, anxiety, and time-wasting out of their busy trading days.
It’s exactly what we’ve always dreamed of as traders. If you want to streamline your trading process each day, check it out. Try StocksToTrade for 14 full days for just $7!
The Bottom Line
I hope this post helps you decide whether to add short selling to your trading skills arsenal.
There’s no doubt short selling can potentially help traders get ahead, big time. Especially as stock prices often drop much more quickly than they rise.
But remember, there are added risks and costs involved in shorting…
Make sure you understand all the possible pitfalls before shorting your first stock.
Is it time to start shorting? I can’t tell you that.
But I can give you advice and support to help you when you are ready.
Does short selling seem like a good fit for you? What are your shorting-selling experiences? Leave a comment below — I love to hear from readers!
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