Did you know that there’s a way to potentially profit from stocks that are declining in price or losing value?
It’s called short selling, and it’s a method that traders have been using practically since the beginning of the stock market.
If you’ve seen the movie “The Big Short” (one of our favorite stock trading movies) then you probably have a basic idea of the mechanics behind short selling. While that’s an extreme example, it’s a technique that can be employed by everyday traders, even those with small accounts.
Here, we’ll delve into short selling on the individual trader’s level — explaining what it is, how it works, and some of the considerations to keep in mind if you’re interested in pursuing this style of trading.
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Table of Contents
What Is Short Selling?
Think about the traditional method of buying stocks: buy low, sell high. Now, turn that idea upside down. That’s what short selling is.
Basically, the idea behind selling sort is that you have an opportunity to profit when stocks are going down.Short selling is completely legal, and it’s a trick that has been in the day trader’s repertoire for over 100 years.
Legendary trader Jesse Livermore used this method of trading.
Here’s How Short Selling Works
1.) First, you borrow shares from a broker.
2.) Then, you sell them at a low price, taking a negative position. So, if you were shorting 1,000 shares, you’d see -1,000 shares (yes, that’s a negative sign) in your account. Right now, you’re hoping that they will continue to lose value.
3.) Then, you buy back the shares, giving you a zero position. Ideally, you’d buy them back at a lower price than you sold, and the difference would be your profit.
It’s a strange thing to wrap your mind around, and it might seem complicated at first.
But just remember: you’re still buying, and you’re still selling. In that way, it’s just like a traditional transaction. But you’re kind of doing things in reverse.
Why Sell Short?
Short selling can provide many benefits to both investors and to the stock market at large.
For one thing, short selling helps create liquidity in the market and keeps stocks from being inflated due to hype.
For another, short selling has the potential to generate impressive profits. If a stock continues to lose value after you’ve initiated the trade, you stand the potential to profit handsomely from the process.
Short Selling: What to Look For
Want to short sell, but don’t know what to look for? Here are some signs to look for in contenders:
- Fluff news: Is a stock up, but without any real news? It could mean that the news is without real merit, and the price will soon go down.
- Sympathy trades: If a stock is up because of news within the sector that has nothing to do with the company in question, prices could be poised to fall soon.
- RSI: If a stock has a low RSI (relative strength index) on the 12-month daily chart, it could be a sign that it’s ripe for short selling.
- Bad financials: if a company is benefiting from a current trend or fad, but has bad financials, it could be a good choice for shorting.
Is it Dangerous?
Plenty of people have a negative view of short selling. But why?
Mainly, because there’s a high level of risk associated with this method of trading. There are a few ways in which you as a trader can potentially suffer losses.
One risk is that, quite frankly, the system can work against you. Sometimes, when traders and investors notice that a stock is being shorted heavily, they’ll try to drive up the stock price.
The short sellers are then forced to cut their losses and repurchase the shares before the stock price rises too much and they lose too much money.
Another risk is that when you short sell, it’s not a given that you’ll be able to repurchase all of the shares you want to buy at the price you want to pay.
You need to look closely at the volume and liquidity of the stock in question. If there are too few sellers, or if there are too many people trying to buy, you can be shut out and incur some serious losses.
Yet another risk is that the stock could go up in value. For instance, what if you took a short position, only to learn that a big company like Amazon is partnering with the company offering the stock you’re shorting? This could raise the price, which will impact your short-selling position in a negative way.
Ultimately, perhaps the scariest risk associated with short selling is that while the potential earnings are extremely high, the potential losses are potentially unlimited … and that potentially stinks in a big way. The stock price could possibly keep on rising, mounting your losses ever higher.
Yes, short selling carries a substantial amount of risk. Be sure to consider these things before you execute trades:
- It’s a short-term strategy: Short selling isn’t intended for long holds. There are also restrictions that prevent it from being a sustainable long-term strategy.
- Consider the market: A bear market is generally better for shorting than a bull market.
- Beware of low-float stocks: These are prone to short squeezes.
- Look at the market: Even if a stock makes serious gains in the morning, it can lose value in the later hours unless the news or a catalyst is significant.
Try STT Pro!
One thing’s for sure: You need to do your research before pursuing short selling. StocksToTrade Pro is the ultimate weapon for good in this regard. By employing our state-of-the-art charting software, you can perform the technical analysis that is so necessary for choosing stocks.
While there’s no wrong time to join STT Pro, right now is perhaps the best time ever, on the eve of our broker integration, which means that you can perform research and execute trades right from the platform!
Conclusion: Short selling is a method of trading that can potentially provide great gains for traders. However, it’s not without its fair share of risk.
To make the most of your short-selling efforts, it’s important to do plenty of research and to consider the market conditions.
By joining StocksToTrade Pro, you’ll be equipped with many tools that can help you make smarter decisions about trades, whether you’re short selling or otherwise.
Have you ever sold short? How did it go? Leave a comment below.