Short Selling Explained: How To Do It and When You Should

Short Selling Explained: How To Do It and When You Should

Short Selling Explained: How To Do It and When You Should 1024 546 Steven Dux

The Intro.

A lot of new traders make this mistake, and it’s one that can have a huge impact on your trading portfolio (and career as a whole).

They assume that day trading is dependent on the markets, and that it is not possible to turn a profit when the markets dip. But this is simply not the case! But this is simply not the case! And today, I’d like to bust this myth so you can take advantage of where most new traders fail.

None of this is to say that there aren’t risks during a failing market, but it holds more opportunities than you might think.

In fact, this is how I’ve built a $5+ million portfolio over the last few years. It goes against what most traders do, but that’s the whole point.

A bit about

Short selling.

So today, I’d like to focus on the most misunderstood yet one of the most important techniques in day trading: Short Selling.

Short Selling, or Shorting, often leaves beginners scratching their heads in confusion because it’s the complete opposite of how we do transactions in general. Assuming you want to invest in some stocks today, you buy them, hope for the price to rise to a profitable level, sell the stocks, and then pocket the difference. That is how you make money trading normally. You buy first and then sell. This is called “going long.” Shorting works differently. While shorting, you sell a stock first at a high price, and then buy it once the price falls. But, in order to sell something, aren’t you supposed to own it first? Not in this scenario. Let us get to the bottom of this short position meaning.

Long VS. Short

In stock market trading, two terms that are used often are long and short.

You’ve probably come across these terms in your research on investing. It’s important to understand some fundamental differences between the two. The first major difference is in what action actually happened first: buying or selling. A long trade happens when a trader buys a stock hoping the price will go up eventually, and then sells it at this higher price, earning a profit. So, the act of buying happens first. This kind of buying-selling behavior happens in a bullish market (ie: when the prices are likely to go up). So basically, the idea is to buy low and sell high. The price you’re selling it for minus the price you bought it for is your total profit.

While shorting, this sequence of transactions is the complete opposite.

The act of selling happens first. The trader sells a borrowed stock in the hope that the price will fall down, and when it does, they sell it at this new low price, making a profit. This can be done in a bearish market and is a good way to earn profits even if the overall market falls. If you have reasons to trust that a market is going to go down (bearish trend), you can make profits by short selling.

Shorting Explained

The traditional way of making money in stock markets is to buy low and sell high.

Assuming you purchased a stock for $10 and over a period of time the price jumps to $15, you sell it and make a profit of $5. In short selling, you will sell a stock without having to buy it first. You will borrow it from your broker, and once the price falls, you sell it. So let us assume you sold the stock at $20 first, and then bought it at $12. Your net profit (barring any fee) is $8. A trader does this in scenarios where they realize certain stocks are overvalued — or have inflated prices at a certain period of time — and the price is bound to come down. In such cases, the trader borrows these stocks from a broker, sells them in anticipation of the price crash, and then buys them back when the price falls.

The difference between the two prices will be the profit for the trader.

So the crux of short selling is that a trader loans stocks from their broker and attempts to make a profit. But let me say this before we go any further because shorting does come with a lot of risks. That’s just the reality of it. Before you decide to short, you need to be sure to gain as much knowledge on it as possible, and to then practice these sort of traders over-and-over. But don’t worry. We’ll get into that in a moment. First, let’s dive into how short selling works.

How It Works.

The steps involved in short selling a stock:

1. Borrow the stock you think will be going down soon.

Get in touch with your broker to find shares of the stock and ask to borrow the shares. The broker will find you the trader who owns the shares and borrow them. The shares then get allocated to you at a predetermined fee and/or interest.

2. Sell the shares you borrowed.

The cash from this sale gets credited to your account.

3. Wait for the stocks to fall in price.

Keep an eye on the stock as you wait for it to fall.

4. Buy back the shares at a lower price.

You then buy back the shares when the price hits an appropriately low amount.

5. Return the borrowed shares.

You can sell by borrowing a stock from your broker and then short selling it.

Technically, you don’t own these borrowed stocks.

You’re selling it with the assumption that you’ll buy it back soon. When you do buy it back, this step is called covering your short. Now you’ll keep with yourself — as profits — whatever you earned initially while selling minus what you spent in buying.

To remember this correctly for the rest of your trading career: Sell when prices are high, and then when the price reduces you buy. That is how you short.

Opening & closing

a short position.

In order to close a short position, a trader must buy the stocks back optimistically at a lower price than what they borrowed it at and return them to the broker. To open a short position, a trader must have a margin account and will typically have to give interest on the borrowed stocks while the position is open.

Here is an example to illustrate this for you. Let’s say you notice the stock of XYZ company just got involved in a controversy. The stock is currently priced $10 and you can tell that the stocks of that company are going to fall in price pretty soon.

So you contact your broker and borrow a 1000 shares of that stock, and then sell these shares at $10 each and wait for the price to drop. The thing to remember here is, this isn’t your money yet. You have sold borrowed stocks. It only becomes your money once you buy these shares that you sold. Your account will illustrate that you are at -1000 shares and that will only balance out to 0 when you buy the shares. So assuming the price drops to, say, $6, you then buy them back and return them to the broker to cover your short. Your net profit, other than any interest or fee, is $4000. This is how you make money even when stock prices fall.

Risks Involved

As effective as shorting a stock is, there are risks involved in short selling.

Shorting can present big returns when done right, but also carries potentially big losses. Once you have sold a stock after borrowing it, it is not necessary that you will always be able to buy it back at the price you want. After all, the market can be unpredictable. And you are essentially betting against a stock. If the stock goes up above the price you borrowed at, you’re losing money. You’ll be losing money because you’ll have to pay an increased price to buy back the shares and return them to the broker’s account. It can also prove to be expensive because you have to pay dividends or interest on whatever you borrowed. The longer you hold on to a stock taken on loan, the lower your profits.

Not to mention the fact that your losses can be unlimited if the short does fail.

If you borrowed and sold 100 stocks at $100 each, you earned $10,000, and let us say the stock price goes up to $150. You will have to buy them back at $15,000 (because you owe them to your broker), meaning you lose $5000 in the process. This loss amount can keep increasing the more the price of the stock rises. You should never take for granted that you can repurchase a stock when you want and at the price that you want.

If you go long, the maximum amount of money you can lose is 100%.

Whereas when you short a stock, you can lose way more than 100%! Because of limited profits and limitless risk, shorting is not something I recommend for absolute beginners (or if you don’t have enough backup funds). Moreover, not all stocks are always available for shorting. This brings down the pool of stocks available for you to trade. It is definitely not for the faint hearted but it has become my preferred strategy and I would encourage you to try it out once you build some momentum with your day trades.

The Benefits

Traders who understand the risks and are prepared for the potential losses can yield big wins through short selling.

Simply put, short selling allows traders to make money even in a declining or bearish market. Because the usual expectation in a market is that stocks will rise in value, most traders do not short. However, there are quite a few opportunities to short as prices DO fall. When you’re calm while shorting, you offer yourself more opportunities to make profits. Short selling makes sense if a trader is absolutely certain that a stock is likely to drop in the short term. Which makes this a good strategy for day traders.

If you look at certain stocks and can tell that the price is going to go down, you’re not going to buy them because that way you’ll lose money for sure.

You can borrow and sell the stock. Just like any other loan you’ll have to pay interest.

If your prediction says that the fall in price of the stock is going to be significant enough to cover your interest and leave you with a profit, this is a beneficial scenario for shorting. It’s the only way to make money in a bearish/declining market. Short Selling intimidates traders, and they end up avoiding it entirely, even in bearish markets. But this strategy can be advantageous with good risk management (and timing). Also, you can’t rely on going long every time because you never know how the market is going to react.

Go slow.

Do not try to jump into shorting on day one. As a beginner, your focus should be on learning and practicing rather than jumping into risky techniques without proper initiation. There are fees and interest payments involved in shorting, making the process a little more complex than regular stock trading.

Tips For Shorting.

Here are a few tips to keep in mind before you short:

Do paper trades.

Before short selling in the actual market, my recommendation is to practice with paper trades. Paper trading allows you to buy and sell stocks, just like you would in day trading, without risking your money. I advise my students to prepare themselves for 12-months of studying the markets.

Look at historical statistics.

Don’t just guess that a stock is overvalued and it might fall. Look at statistics and make decisions based on that. Numbers don’t lie.

Manage your emotions.

It’s easy to get carried away in shorting and get greedy. Don’t make that mistake. Base your decisions on patterns and stats, not on emotions. Managing your emotions will manage the risk.

Short selling has a high risk/reward ratio. It can present huge profits, but any losses can substantially increase.

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