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Everyone knows that they can make money by purchasing stocks at low prices and waiting for their values to increase. At that point, you can sell your stocks to earn a tidy profit.
Fewer people know that money can be made by betting on stocks falling. Short selling is a strategy that takes advantage of declining stocks. If you feel intimidated by this option, short selling for dummies will introduce you to popular strategies and how you can take advantage of fluctuations in the stock market.
What Is Short Selling Stock?Short selling is a pretty advanced form of trading. If you don’t have experience investing conventionally, you should probably stay away from it.
Once you feel confident to dip your toes into short selling stock, it makes sense to follow the rules established by short selling for dummies. It's probably best to go slow at the beginning so you can keep the risks as low as possible.
To begin, let’s break short selling stock into a few steps that you can follow easily:
- Borrow a company’s shares whose value you believe will fall soon from your brokerage firm and sell them immediately.
- Pay interest on the borrowed amount to the brokerage you borrowed from. They don’t let you borrow for free!
- When share prices fall as expected, buy back your position. Someone else is willing to buy the shares from you at the current price, which lets you pocket some cash immediately. Or, wait for the stock’s value to keep falling, which gives you a chance to buy shares at even lower prices.
- Return the shares to the brokerage and keep the difference between the previous and current values. Minus the fees and interest, of course.
Now, let’s get into how you can accomplish these steps.
How Do You Borrow a Stock to Short Sell?Assuming that you already have an account set up at a brokerage firm, you can start borrowing stocks to short sell fairly easily. For example, a heavily traded stock like Apple could be shorted quite easily.
You need to start by opening a “margin account” with your brokerage. A margin account lets you borrow against the investments in your portfolio.
How much can you borrow? The amount differs depending on your brokerage. Generally, you can expect to borrow up to 50% of your portfolio’s value.
Keep in mind that the more you borrow, the more you could lose. If you can’t afford to lose 50% of your portfolio, it’s probably not a good idea to risk that much.
Some benefits of margin accounts include:
- Letting you borrow stocks that you want to short.
- Giving you access to funds when your brokerage isn’t open.
- Making it possible for you to buy trending stocks outside of your brokerage’s hours.
- Allowing you to enter options trades, such as credit spreads.
How Long Can You Short a Stock?Technically, you can short a stock for as long as you want. In practice, your brokerage may have limits that define how long you can borrow the stocks you want to short.
Even if your brokerage doesn’t enforce limits, it may continue to charge you interest on the borrowed stock. Eventually, the interest charge will offset any profits that you make from the short sell. You may even lose money if your interest charges get high enough.
If your brokerage lets you borrow a stock to short indefinitely, take a close look at how much money you stand to earn or lose. You get to make the decision, so it’s unfair to call the brokerage’s action “predatory.” You may, however, let the brokerage take advantage of your situation.
What Is a Short Selling Example?All of this talk about short selling can sound a little confusing. Providing a real short selling example should make it easier for you to understand precisely how the investment strategy works.
Let’s take a step-by-step look at an example:
- Find an overvalued stock with a value you believe will crash soon. In this example, let’s use Boeing Co (BA) at the end of 2019. For decades, Boeing’s stock never broke the $100 barrier. In mid-2013, though, the stop stock’s value began an unprecedented climb. The value peaked at nearly $418 on February 2019. Plenty of investors couldn’t believe that such a mediocre stock had reached such a high price. In fact, many of them short sold the stock. By March 20, 2020, the price had dipped below $100, again, partially because of the COVID-19 pandemic.
- Place a short trade with your broker by borrowing the stock you want to bet against. Before you accept the exchange, check the interest rate and related fees. Depending on the amounts, you may decide that you’re not interested in short selling with your brokerage. At this point, you can forget about short selling or find a brokerage with better rates.
- If you are aiming to make money from a quick share price decline, short sell the stock and buy it back on a dip. You probably won’t earn much, but you could pick up more money than you spent on brokerage fees and interest.
- Wait for the share price to fall more if you plan to earn more from a bigger decline. Depending on how well you time your sell, you could make a significant amount of money from the short sell. With Boeing, you could have borrowed the stock on February 14, 2020, when it was worth $340.49. On March 20, 2020, you sell the stock when it reaches $95. With a 50% margin requirement and no dividends, you will make about $144 per share minus the brokerage’s margin interest percentage.
Can I Short Sell a Stock I Own?Yes, you can short sell stock that you own. This scenario is called “short selling against the box.”
You will need to call your brokerage and have them move your shares.
Most investors, however, do not use this strategy to earn money. Instead, they use it to avoid taxes. The Securities and Exchange Commission got wise to the strategy about 10 years ago. To combat tax-evaders, the SEC issued a rule that prevents you from short selling a stop that falls more than 10% in 24 hours.
If you want to want to short sell a stock that you own, and the value has fallen more than 10% within a day, you will need to open a margin account.
Avoid fines from the SEC and other regulatory agencies by contacting a financial advisor. Ignorance of the law will not protect you from fines and/or even possible jail time. A respected financial advisor should know how you can protect your money without breaking the law.
Short Selling Explained: Pros and ConsInvestors wouldn’t short sell stocks if they didn’t have the potential to benefit. All investments, though, come with benefits and disadvantages. Make sure you understand the pros and cons before you decide to short sell a stock.
Short Selling Stock ProsSome of the short selling stock pros include:
- You can add diversity to your portfolio, making it possible for you to earn money even when the stock market doesn’t perform well.
- Bull markets often lead investors into false sense of security. Short selling can protect you from that mentality.
- You can potentially make a lot of money without putting much at risk.
Short Selling Stock ConsSome of the short selling stock cons include:
- You take a big risk on trusting your instinct that a stock value will fall soon.
- When too many people short sell stocks, it can drive the overall stock market down.
- It’s very difficult to decide when to close a short sale to get the maximum payout.
- You always have to pay your brokerage an upfront fee, whether you earn or lose money.
If you don’t have a robust portfolio that can withstand some loss, though, tread carefully with short selling. It could put you behind your investment goals.
Short Selling vs Puts Buying: Pros and ConsShort selling and puts buying create opportunities for you to make money from falling stock prices. They work slightly differently, though, so you should know the difference before you choose an option.
The Definition of Short SellingThis has been covered above, so let’s keep it simple. Short selling involves borrowing a stock from your brokerage, selling the stocks, and hoping that the values will fall so you can purchase them at an even lower price.
The Definition of Puts BuyingWhen buying put options, you pay a premium to retain the right to sell a stock as its value declines.
You are not, however, required to sell the stock. Ideally, the share reaches a specific value, and the trader chooses to sell. If the share’s value rebounds, then the put buyer can walk away without losing more than the premium paid for the put option.
Pros and Cons of Puts Buying vs Short Selling
- Short selling often has higher margin requirements than buy buying.
- Put buying lets you walk away from a deal that doesn’t go your way.
- Buying puts helps to limit a trader's potential loss.
- Short selling lets investors borrow money against their portfolios instead of spending cash.
You will need to study your portfolio, talk to an investment advisor, and compare your brokerage options before you determine whether you want to use short selling or puts buying.
Is Short Selling Risky?Yes. Short selling is fairly risky. Of course, all investment options are risky. Plenty of experts, however, tell their clients to avoid short selling because it involves a higher risk than other investment options.
Before getting into the risks of short selling, let’s acknowledge that many people have generated income from the strategy. In March 2020, Bloomberg reported than short sellers had made more than $50 billion during the COVID-19 sell-off.
Some of these investors made money because they believed that the emergence of COVID-19 in China would spread around the world, causing a recession. Others were short selling stocks because they could not believe that the market could sustain itself for long. The stock market looked healthy, but the economy was struggling. They shorted stocks because they did not believe this situation could last.
The short sellers who saw conflict between the economy and the stock market may have detected similarities between the real estate bubble and the economy that took place in 2008. During that recession, a handful of smart investors made billions of dollars betting against the market. Adam McKay even directed a feature film, “The Big Short,” starring Christian Bale, Steve, Carell, and Brad Pitt, among others.
Despite the benefits that a small number of professional traders have earned, short selling is risky for average investors. If you want to try short selling, start small and build on your success. Don’t jump in with expectations that you will take advantage of a stumbling stock market. The market has proven itself unpredictable.
Best Stocks to Sell ShortIf you choose to short sell stocks, you need to know which options to focus on.
Stocks With Very Bad FinancialsA company with very bad financials usually owes a lot of money and may struggle to grow profits as revenues rise. They may not even make profits. They probably don’t even break even.
They may, however, have outside funding that keeps them afloat. Funding puts investors in an interesting predicament. For example, Uber is an unprofitable company. It doesn’t make any money. Still, it has a valuation above $50 billion.
Be cautious when evaluating a company’s financials. The numbers don’t always indicate how stock values will move.
Stocks With Negative SentimentSome companies make good products, but they constantly rub consumers the wrong way. Can a company’s stock value remain high when people dislike it?
When you see a lot of negative stories about a company, consider adding it to your list of stocks to short sell.
PG&E Corporation stands out as a good option in August 2020 because people are upset that the company keeps cutting power to California households. Many people also dislike the company because a court decided that PG&E couldn’t get sued for the role its equipment played in deadly wildfires.
Companies Suspected of Fraudulent AccountingIt’s difficult to suspect a company of fraudulent accounting until the SEC gets involved. The SEC uncovers fraud every year, but that doesn’t mean casual investors have access to information that they can use to choose short sell options.
You may pick up on some clues, though, by paying close attention to the news. Citron Research is famous for laser targeting companies that may be suspected of engaging in fraudulent behavior.
The bottom line is short selling gives you a different way to earn money from the stock market. Know your risks and potential rewards before you get involved.
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