By the time you're done reading this article, you'll discover how to successfully short stocks and the pros and cons of learning how to sell short stocks. You'll also learn how and why shorting stocks can be a risky endeavor and come away with some tips to mitigate these risks to your portfolio.
What Does it Mean to Short a Stock?
When you short a stock, you sell shares of a stock that you do not own. You hope to buy the shares back at a lower price later so that you can profit from the difference.
To short a stock, you borrow the shares from somebody else, typically through a broker. You then sell the shares, hoping to buy them back at a lower price. If the price falls, you profit from the difference. If the price rises, you lose money.
How to Short a Stock
Here are some basic steps to follow on how to short a stock.
1. Choose a stock to short.
One way to start learning how to sell stocks short involves looking for overvalued stocks. This means that a stock trades at a price that is higher than its intrinsic value. To find overvalued stocks, use the MarketBeat stock screener, which will allow you to filter stocks based on certain criteria. For example, you can screen for stocks with a high price-to-earnings (P/E) ratio.
Another way to find a stock to short is to look for stocks with negative news. This could include anything from a disappointing earnings report to news of a scandal. When a stock has negative news, it will likely fall in price, which provides an opportunity to profit from the stock's decline.
Stocks with technical problems can also provide good shorting opportunities. Technical problems can be anything from a broken support level, poor chart pattern or an overbought RSI reading. When a stock has technical problems, it will likely fall in price.
You can also look for stocks with high levels of short interest. This means that there are a lot of people betting that the stock will fall in price. When there is high short interest in a stock, it is often because the stock carries a negative sentiment. You can find companies with a high amount of short interest with our highest short interest stocks tool.
Finally, when company executives sell a large amount of their own company's stock, it can indicate an overvalued company share price. This is also known as insider selling, and is often seen as a trading signal that the company's shares will fall lower. (Learn more about insider buying as well, which occurs when company insiders buy large amounts of company stock.)
2. Find a broker that offers shorting.
Not all brokers allow shorting, so you'll need to do your research to find one that does. Once you've found a broker that allows it, you'll need to open an account and deposit money. Once you have an account set up, you can place trades to short a stock.
3. Place a short order with your broker.
When placing a short stock order with your broker, you can provide your broker with the name and ticker symbol of the stock you wish to short, the number of shares you wish to short and your account type (margin or cash).
Your broker may also require you to set up a margin account in order to short stocks. Margin accounts allow you to borrow money from your broker to purchase securities, which can help you increase your potential profits (but may also exacerbate potential losses). Once your broker has all of the necessary information, it will execute your order and short the stock.
4. Monitor the stock price closely.
Next, keep track of the stock's price so you can buy it back at a lower price and profit from the difference. There are a few ways to do this, including using a stock tracking app or website like MarketBeat. You can track the prices of individual stocks and create watchlists of stocks you may want to invest in using our platform.
Another way to track a stock's price involves using a financial website like Yahoo Finance or Google Finance, which provide real-time stock quotes and have charts and other tools that can help you track stock price over time. Finally, you can look up the stock's price on your broker's website. Most brokers provide real-time quotes for the stocks they offer.
5. Close your trade.
When closing a short stock position, you must first buy back the shares you have sold short. This is known as "covering your position." To do this, place a buy order for the same number of shares you sold short. Your broker will then use the proceeds from the sale to buy the shares and you will be left with no position in the stock.
There are a few things to keep in mind when closing a short position. First, you may have to pay a "shorting fee" to your broker. Some brokers charge this fee when you sell a stock short. You will have to pay any dividends that were paid on the stock while you were short, which will go to the person from whom you borrowed the shares, not to you. Finally, you may have to pay a commission to your broker to buy the shares back. Once you have closed your short position, you will no longer have any obligations with respect to the stock.
Shorting a Stock Example
When you learn how to short stocks, you borrow shares from somebody else, sell the stock and hope the price falls so you can buy it back at a lower price and return the shares to the person you borrowed it from.
For example, let's say you believe XYZ stock is overvalued at $50 per share. You could borrow 100 shares from a broker and sell it immediately. If the price falls to $40 per share, you can buy the shares back, return them to the broker and pocket the $10 per share difference. However, if the price of XYZ stock goes up to $60 per share instead, you will have to buy the shares back at a higher price and will lose money on the trade.
Pros and Cons of Shorting Stocks
Carefully consider some pros and cons of selling short a stock before you get started.
Pros of Shorting Stocks
Shorting stocks can confer several benefits:
- Make money: The most obvious advantage of selling stocks short is that you can make money when the market goes up as well as down.
- Control a larger investment: Shorting stocks also allows you to control a larger investment with a smaller amount of money. You pay a fee upfront and pay the rest when the trade closes, reducing needed capital.
- Portfolio hedge: You can also hedge your portfolio if you have long positions, which can help mitigate risk and volatility.
Cons of Shorting Stocks
There are some cons to selling stock short as well:
- Riskier: It may be riskier to short stocks rather than buy and hold them over the long term. Shorting stocks can lead to unlimited losses if you do not use a stop-loss order, which is a type of order that can help you limit losses on a particular stock.
- Impossible to predict the market: Predicting if and when a stock will fall can be difficult, potentially leading you to hold a position for longer than anticipated and incurring additional costs.
- Premium charges: Most brokers will charge you a premium for shorting stocks, which can eat into your overall profits.
Risks of Shorting Stocks
Short selling stock can be a risky endeavor — it can go wrong in multiple ways. Here are some risks to consider.
There is no limit to the amount of money you can lose when you short a stock. If the price of the stock keeps going up, you will have to keep buying it back at higher and higher prices. The losses can theoretically keep mounting forever, as there is no limit to how expensive it can get.
A short squeeze is a trading scenario in which a heavily shorted stock or other asset surges in price, forcing short sellers to buy it back at a higher price to avoid further losses. This buying pressure can drive the price even higher.
During a short squeeze, the price of the stock or other asset rises sharply, often to much higher levels than where it was trading before the squeeze started. This increase in price can force short sellers to buy the stock back at a higher price to avoid further losses. As short sellers buy back the stock, the price may rise even further, which can be difficult for short sellers to cover.
When a stock price falls and a short seller's position is "called away," the short seller must buy the shares to cover the position.
A margin call occurs when the broker demands that a short seller provide additional cash to cover the losses on the position. If the short seller cannot or does not provide the cash, the broker may close out the position by buying the shares and selling them to the short seller at the current market price.
In the case of a dividend payment, the short seller must pay the dividend to the person from whom they borrowed the stock because the short seller does not actually own the stock and is therefore not entitled to the dividend. The short seller must pay the dividend even if the stock price falls — they are still responsible for the borrowed shares.
This can have a significant impact on short sellers because it reduces the amount of money you make when the stock price falls. In some cases, it can even result in a loss. For example, if a short seller borrows shares of a stock that pays a $1 per share dividend and the stock price falls by $1, the short seller will break even. However, if the stock price falls by $2, the short seller will incur a loss of $1.
Does Shorting Stocks Make Sense for You?
Shorting stocks is an advanced trading and risk management strategy that may help you make profits and protect your long positions during a market downturn. On the other hand, you take substantial risks when you short stocks, including the possibility of incurring unlimited losses.
Choosing another type of investment or trading approach, such as our picks of the most active stocks or forex (learn more about forex in "What is forex?")