In the stock market, the time-honored wisdom is to buy low and sell high.
But did you know there’s a technique that flips that traditional approach, where traders can potentially profit from stocks that are losing value?
It’s called short selling, and it’s a technique that traders have used since essentially the dawn the stock market.
In this post, we’ll explore all things short selling: what it means to short a stock, how it works, and key facts to know before pursuing this style of trading.
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Table of Contents
What Is a Short Sell?
So … how does short selling work?
In the stock market, a short sell doesn’t just refer to a position you briefly hold. It’s actually a specific technique of borrowing, selling, then re-buying shares in hopes of earning profits.
It might sound daunting, but it’s way simpler than it sounds. Let’s dig in.
What Does It Mean to Sell Short?
Before you can understand how to short sell, you need to understand the mechanics behind this trading style.
Have you seen the movie “The Big Short”? If so, then you may already have a basic understanding of how short selling works. In the movie (based on a true story, BTW), a Wall Street mover-and-shaker forecasts the massive housing crash before it happens in 2008.
Realizing that a massive number of subprime home loans are on the verge of default, he bets against the housing market and profits bigtime when the crash he predicted hits.
That’s a pretty clear-cut example of short selling, if not the type of opportunity that comes along regularly. On a daily basis, short selling is a technique used by traders who find and bet against stocks that they think will lose value.
Some consider short selling a sort of ethical grey area, but in fact, it’s completely legal. It’s actually a trick that’s been used for over 100 years — legendary trader Jesse Livermore was an avid short seller.
Benefits of Shorting a Stock
Alright, you’re probably feeling a little more comfy with short selling. So what’s the benefit of shorting a stock? There’s actually more than one benefit. Here they are …
Adds liquidity to the market. Short selling can help create liquidity in the market. It can also act as a system of checks and balances, preventing stocks from overinflating on hype.
Opportunities in bear markets. A bear market is marked by dwindling prices, pessimism, and tight pockets on the part of big investors. That can be a huge downer if you want to buy low and sell high. This can be a shining moment for short selling: an opportunity to profit even in a market downturn.
Potential for profits. Here’s where short selling gets real juicy … It has the potential to yield profits. If the stock price continues to decline after you initiate a trade, the profit potential could keep mounting, but always keep in mind that this trading style also comes lots of risk.
How do you short a stock? Here’s how.
How to Short a Stock With a Screener in 6 Steps
Learning how to short a stock isn’t incredibly complicated. To help you on your way, here’s your easy-to-use six-step guide.
#1 Identify the Stock With a Stock Screener
Before you can sell short, you need to figure out what stock you’ll target in your trade.
At this point in the process, StocksToTrade Pro is your BFF. Our state-of-the-art software can assist you with both the fundamental and technical analysis necessary to find opportunities. Here’s how:
News Catalysts
If you want to know how to short a stock, you need to understand how the news (or lack thereof) can lead you to potential plays.
For example, maybe you notice that a stock is up, but without any real or specific news. That can mean it’s up due to pure speculation and buzz. Watch this stock — the price might drop in the near future.
Patterns and Indicators
Patterns and indicators also essential players when learning how to short a stock.
StocksToTrade includes charting software for line, candlestick, and bar charts. And you can tailor those charts to different time frames, from seconds to hours, weeks, months, or years.
Nope, you’ll never know exactly how a stock will perform in the future — there are just too many variables at play. However, by evaluating a stock’s past performance through its chart and indicators, you can make more educated predictions about its possible future performance.
Stock Watchlist
Perhaps the most important part of your education on how to short a stock is learning how to create a strong stock watchlist.
A watchlist is a short list of stocks you’re considering for trades. It’s generally better to limit this list, so you can easily monitor your tickers on a regular basis.
The idea is to keep an eye on your selected stocks, watching to see if they meet your trade criteria. If and when that occurs, you can take further steps with the stock in question.
When creating your list of short-selling contenders, here are a few things to consider:
- Weak news: If a stock’s price has gone up without a good news catalyst, the price might soon decline.
- Sympathy trading: Sometimes news within a sector can affect a number of companies, even if the news doesn’t directly relate to them. This phenomenon is called sympathy trading. And, often, stock prices that rise on sympathy will drop in price soon.
- Relative Strength Index: Does a stock have a low relative strength index (RSI) on its 12-month daily chart? This can be a sign of a good pick for short selling.
- Weak financials: When you review a company’s earnings report, do the finances look weak or just downright bad? It might be a good short-sale candidate.
#2 Borrow the Stock
Once you decide to initiate a short sale, you can either reach out to your financial advisor or hit up your online broker. You need to declare it as a short sale order from the get-go.
From there, your broker will try to borrow (yes, borrow) the shares. The shares can come from a number of different places, including another client’s margin account, another broker, or from the broker’s own inventory.
Important note here: Just because you want to make a short sale doesn’t mean it will happen. If your broker can’t find shares to borrow, your trade can be dead in the water before it even starts.
Also note that not every broker permits short selling. If you’re interested in short selling, check if it’s available with the broker in question before creating an account.
#3 Sell the Stock
The next step in short selling stocks is to sell your shares.
Soon after borrowing the shares, you sell them at a low price, which means that you’ll assume a negative position. So, say that you’re shorting 5,000 shares of a stock. In your account, that registers as negative (-) 5,000 shares.
#4 Wait for the Stock Price to Decline
Now for the hard part: watching and waiting. Once you sell the shares, your hope is that they’ll continue to lose value. Depending on the stock, this can be a matter of minutes or can take longer.
You need to closely monitor the price — you don’t want to find yourself locked into a losing trade.
Here’s where a trading plan is a great asset to short sellers. A trading plan helps you plot your course of action for a trade, including your entry and exit points. So if the price action starts to move against you, you know when to cut your losses … it’s all laid out in your plan.
#5 Buy Back the Stock
For now, let’s stick with a best-case scenario. Let’s say that the stock price sinks to your plotted exit point. At this point, you buy back the shares, which will balance out your account to a zero position.
Ideally, you’ve bought the shares back at a lower price than what you sold them for. In this case, the difference would be your profit.
Unfortunately, if the price goes up, you’re still obligated to buy back the shares. After all, you borrowed them, and they need to be returned intact.
Here’s the tough part: If the price goes up, you’re responsible for the difference.
#6 Return the Stock
The final step in shorting a stock is returning the shares, via your broker, to whomever you borrowed them from.
Key Tips on How to Short a Stock for Day Traders
Here are a few more things you need to know before you jump into short selling:
When It Comes to How to Short a Stock, Don’t Trust in Promoters
Don’t believe the hype. In general, stock promoters are out to serve themselves. You can certainly listen to what they say, but never make final decisions based on their advice.
In fact, sometimes promoters can inadvertently alert you to short-selling opportunities. If promoters are massively hyping a stock, it can be in an effort to inflate the price and then drive it back down. That’s called a ‘pump and dump’ scheme.
For savvy traders who can spot a pump and dump, this can be an opportunity to make a short sale on the promoters ‘next big thing’ stock.
Don’t Trade Too Big and Choose Only High-Volume Stocks
You want to protect yourself as much as possible as a short seller, of course. Follow these tips to help you do just that:
Don’t trade too big. Short selling can come with a high level of risk. If the stock price stock doesn’t decline, you’re responsible for the difference in price. You don’t want to find yourself in a trade where you suffer a huge loss. And a massive position can mean a massive loss!
Look for high-volume stocks. Volume refers to the amount of shares that are being bought and sold within a trading day. It’s a big deal when it comes to short selling.
Why? If there’s not enough volume, you can hit your perfect exit point for the trade, only to realize you can’t get out because there aren’t enough buyers. Nobody likes being stuck in a trade. Be sure to check the volume before executing a short sale.
Take Your Trading Account to The Next Level With a Stock Scanner
Short selling has an assertive level of inherent risk. To better position yourself, you need to thoroughly research every single trade.
You can never know exactly what will happen with a stock. But knowing a company’s fundamentals, past price action (its chart), and various indicators, can give a better idea of how the trade can play out.
StocksToTrade has all the tools you need to research stocks and help you construct a solid trading plan.
Conclusion
Short selling is a different approach to trading where traders can potentially benefit from the declining prices of securities.
But don’t be blind to its perils! While the potential for profit is substantial, this trading style comes lots of risk.
Before pursuing short selling, as always, you gotta do your research. Newbie and seasoned traders can step through the process by paper trading before executing real trades.
StocksToTrade can provide you with the tools you need to make intelligent trading decisions, whether you go long or short on a stock!
What’s your experience with short selling? How does short selling factor into your trading plan? Leave a comment below!