If you’re like most casual investors, when you think of Wall Street, you probably think of cash flying in the air when the stock market is soaring. But growing stock values aren’t the only way to make money on the market. Any good investor knows that there is a silver lining to every gray cloud, and in this case, you can also make money when the stock market goes down with a little strategy called short selling.
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If you’re like most casual investors, when you think of Wall Street, you probably think of cash flying in the air when the stock market is soaring. But growing stock values aren’t the only way to make money on the market. Any good investor knows that there is a silver lining to every gray cloud, and in this case, you can also make money when the stock market goes down with a little strategy called short selling.
How to Short Sell a Stock
- Open a Margin Account with a Brokerage
- Research and Identify Struggling Stocks
- Create a Short Order
- Close the Short Order
The two most common strategies consumers associate with the stock market is buying and selling stocks and buying and holding stocks (often for dividends). In the first case, traders hope to capitalize on market swings by purchasing securities when the price is down and selling them when the price goes up. In the latter case, investors purchase shares in companies they believe have long-term growth potential, hoping the value of their portfolio swells when that stock increases, along with reaping the rewards of dividend payouts.
Retail investors often wonder how people really make money on Wall Street. They may ask themselves this question after buying a stock they thought would go to the moon, only to end up losing money instead. Or they may ask themselves this same question after reading about wealthy investors who live off dividends and wondering when their stock portfolio will generate enough dividends to retire.
What these casual retail investors often don’t realize is that, more often than not, the real money made on Wall Street is acquired using alternative strategies, like margin trading or by trading on derivative markets. The reason these options accelerate earnings is because they can amplify the return of a trade or investment while creating opportunities for profit in adverse market conditions when normative investing strategies often lose money. One popular strategy used to profit in a declining market is short selling stock.
What Does It Mean to Short Sell a Stock?
Short selling a stock means borrowing shares of that stock and selling them. As the price of that stock declines, the trader repurchases the stock so they can return it to the party they borrowed it from, which more likely than not, is going to be the stock broker or brokerage firm they use to buy and sell stocks.
Short selling may also be referred to as taking a short position, which is the opposite of taking a long position. Taking a long position means buying and holding, whereas short selling is very much the opposite: you are so confident that a stock price is going to go down, you’re willing to sell shares you don’t even own and rebuy them at a lower price to return them to the owner at a later date; pocketing the difference.
Short selling should not be confused with options contracts, though there is some similarity to short selling and a put option. To briefly explain, an options contract gives the trader the right, but not the obligation, to buy or sell stock shares at a certain pre-set strike price. With a put option, the trader is banking on the price of the stock falling, so they purchase a put option contract that gives them the right to sell the stock at a certain price. If it falls below that price, they’ll buy the stock at market value, and exercise the option right to sell it at the higher strike price. It’s similar to short selling in that the trader is banking on the stock price declining, however, it’s different because with short selling, you don’t actually need to buy the stock, you just have to borrow it.
What Are the Rules of Shorting a Stock?
Short selling has often been blamed for market crashes, and has been banned on several occasions.
The Amsterdam Stock Exchange banned short selling in the early 1600s when a prominent trader was believed to be manipulating share prices of the Dutch East India Company. The British Crown also outlawed short selling after the South Sea Bubble Pop of 1720. Fast forward to 2008, and governments in the United States, United Kingdom, and several other countries banned short selling for two weeks in hopes that it would help the markets recover. However, these measures are usually only temporary, and short selling is a normal part of trading activity.
For many years, short selling was regulated by the Uptick Rule. This rule was instituted in 1938 towards the end of the Great Depression. The rule stated that short selling could only occur for a given security if the price of the stock increased from its most recent previous sale. The Uptick Rule was repealed in 2007 after the SEC found it did not alleviate the downward trend of a bear market. However, after a number of traders took advantage of short selling in the 2008 financial crisis, they have since implemented a variation of the Uptick Rule that imposes a freeze on short selling for securities that have dropped 10 percent in price from the previous day.
Another rule imposed since the 2008 financial crisis is that the stock must truly exist and be accessible through a broker or brokerage. If it isn’t truly accessible, then it is called Naked Short Selling or Naked Shorting. This occurs when there are discrepancies between electronic and paper trading systems. Naked shorting typically occurs in market sectors where shares are more limited, such as companies with a smaller market cap. Just a few years ago, it was suspected that naked shorting was a problem in the cannabis industry. Penny stocks are also often venues where unscrupulous short selling and pump and dump schemes take place.
How to Short Sell a Stock
Now that we’ve explained what short selling is and the rules that regulate it, let’s get into the nitty gritty of what you need to do if you want to short sell a stock:
1. Open a Margin Account with a Brokerage
Your brokerage is not going to let you engage in short selling without a margin account. If you’re wondering what margin trading is, it’s essentially loaned money that the brokerage provides using the stocks in your portfolio as collateral.
The reason you need a margin account is because you are going to be selling stocks you don’t own and then buying them back. If something doesn’t work out, your broker or brokerage firm will want their assets (or at least their monetary equivalent) back.
Each platform will have its own requirements as it relates to providing a margin account. For example, some brokerages will only provide margin if your portfolio has a certain dollar value, or they will only provide a margin account that equates to a percentage of the portfolio value. Whatever the case may be, what they get out of the arrangement is collecting interest in the form of a periodic margin call. This is one of the biggest risks of margin trading and short selling. If your trading activity does not make money, the margin calls will need to be settled with cash.
2. Research and Identify Struggling Stocks
Once you have a margin account, it’s time to figure out which stocks have a bearish outlook—that is, investors and analysts believe the stock’s price is likely to decline.
This can be done using analytic software, similar to the ones used by day traders, or it can be done by staying on top of financial news and getting a general sense of which companies are performing poorly.
Either way, once you’ve pinpointed the potential struggling stock you’d like to short, it’s time to create a short order.
3. Create a Short Order
You can create a short order by calling your broker or requesting it through an online brokerage platform. Many of the best trading apps will let you create such short orders right from your phone, but not all of them.
Remember, the ability to place short orders for certain securities may be blocked if the price has dropped 10 percent since the previous day, so pay special attention to the stock charts before placing an order.
4. Close the Short Order
There is no time limit for short orders, but there are factors that will dictate when you want to close it out.
One is the price of the stock itself. If the price starts going up again, you are looking at a loss because you are going to have to buy the stocks back at the higher price in order to return them. For these reasons, most short sellers don’t let their short order linger for too long.
If the time comes for your brokerage to collect their margin call and you haven’t made a profit off the short sale, you will have to fork over cash or liquidate your assets to satisfy your financial obligation.
Thankfully, you don’t have to personally locate the shares and return them, the brokerage handles that part on their end. However, it is still good to know how the ins and outs of how short selling and options contracts work. You can learn more about these strategies and others by joining our Weekly Stock Trading Room.
Example of Short Selling for Profit
Let’s say a stock has a current market price of $100. A short seller that has done their research has determined the company is going to report less than satisfactory earnings, and thinks this will lead to a decrease in stock value.
The trader borrows 500 shares of the company stock when the share price is $100 and sells the borrowed stock to another trader or investor. Now our trader has made $50,000 from the sale (minus fees). Just as predicted, the company reports earnings below its target, and the stock prices drops to $75 per share over the course of a week.
At the end of the week, the trader decides to close their position by purchasing 500 shares of the same company so they can return the borrowed stock to the brokerage that loaned it to them. This purchase will only cost the trader $37,500 because the price went down 25 percent. The short seller will then return the stock to the broker, but pocket $12,500 in profit—the difference between the $50K they picked up from selling the borrowed stock and the $37.5K they needed to get it back.
Keep in mind that fees and short interest may eat away at these profits a bit, but as far as trading strategies go, it has still certainly been worth the effort to sell the borrowed shares.
Example of Short Selling at a Loss
Now imagine a second trader decides to try short selling stocks. This trader is thinking about short selling 100 shares of stock with a market price of $200 per share. According to the software program they regularly use for day trading purposes, this stock is likely to take a dive very soon.
The trader contacts their broker and borrows 200 shares, selling them off for $20k. An unexpected event obliterates this company’s competition, and the company has an amazing opportunity to step in and gain a huge portion of the market share. This sends the stock price soaring to $300 per share, as excited speculators drive the price higher and higher with their frenzy of purchasing.
Now, our trader is in trouble, and worried that the price may climb even higher. So, they decide to close out their position, resigning themselves to the fact that they will lose $100 a share. Remember, there is no time limit that regulates when a trader shorting stock has to close out their position by returning the shares, but in this case, the trader feels like it’s best to cut their losses.
What Are the Risks of Shorting a Stock?
Short selling is not without risk. If you don’t have technical indicators that can provide you with algorithmic analysis and guidance of a security’s price, you might as well consider yourself to be shooting in the dark and hoping that the price of a given security continues to tumble. Of course, you might have some insider knowledge that a stock price is going to go down, but that could put you in legal trouble if you act on it.
Even if you feel confident that a stock price is going to drop, sometimes factors outside of your control will drive the price back up again, putting you into what is known a short squeeze. This is exactly what happened with Gamestop a few years ago. Hedge funds were short selling shares of the company because they believed it had an extremely obsolete business model. However, casual investors on the r/wallstreetbets Reddit forum banded together to buy mass shares of Gamestop stock, which in turn drove up the price and ruined the hedge funds’ short selling plans—so much so that some of them were financially destroyed beyond recovery.
While that may not happen to you, it’s certainly still a risk. Since the price of a stock can go up with no limit, your potential losses on a short sell are infinite. Even if you sell as soon as possible to cut your losses, you will still walk away losing money. Though if everything works out according to plan, you can pocket a decent amount of profit.
If short selling sounds complicated, that’s because it is. Generally speaking, any kind of derivative activity around stocks is going to be more complicated—options contracts, short selling, and binary options included. It is somewhat possible to mitigate the risk by short selling ETFs, including index funds. These funds reflect broader markets, but can be bought and sold like stocks.
For example, if it’s evident that economic times are lean and the market is headed downward, an ETF reflecting the overall stock market or stock market indexes is going to move down as well, making it likely that a short sale that will work out in your favor. In fact, it’s very common for brokers and traders to use similar short selling strategies to keep their clients’ retirement planning on track by offsetting the temporary losses they experience from price decreases in long term holdings.
Short Selling is a Great Strategy for Profiting During a Bear Market
While short selling stocks may seem a bit complicated, the good news is that the brokerage does most of the work for you. The short seller’s responsibility is to pick the right stock with a price that is going to go down. It doesn’t require a crystal ball, so much as it does the skill to research the public information available about a company on the market or to use algorithmic software to predict which companies are likely to fall. Even so, it can still be difficult to turn into profit, especially when outside market forces are involved.
But if the excitement of short selling sounds appealing and you have a willingness to learn, a great place to start is by signing up for a free Infinity Investing membership. Our experts and professional tools will guide you through proven investing strategies that will help you generate wealth for many years to come. Don’t put your financial future off another day—get started today!
Bonus Video:
Infinity Investing Featured Event
In this FREE event you’ll discover how the top 1% use little-known “compounders” to grow & protect their reserves. Our Infinity team of experts show you how to be the best possible steward of your finances and how to make your money and investments work for you instead of you working for them. Regardless of your financial situation today, you’ll have a road map to get to where you want to be.