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How To Short A Stock, Is It Worth The Risk?

04/01/2020

How to Short a Stock

Shorting (sometimes referred to as “short selling”) is a trading strategy in which you sell shares of a stock that you don’t own and buy them back later, ideally when the price has fallen. Shorting can be a great way to earn quick money in the stock market, especially during times when the market is highly volatile. But how can you start shorting — and where should you even begin when it comes to opening a brokerage account?

Today, we’ll introduce you to the advantages and disadvantages of short selling to help you decide if this trading strategy is right for you. We’ll also walk you through a step-by-step guide to making your first short.

What is Short Selling?

When you short a stock, you borrow a select number of shares of stock from your broker to sell and then later buy back, hopefully when the stock has dropped in price. Essentially, shorting is betting that a stock will decline in value. This is the opposite of traditional stock investing, which aims to buy undervalued investments and see them gradually rise in value over time. If the stock doesn’t drop in value from the time you buy and instead starts to increase in value, you’ll still need to re-purchase the stocks you borrowed — and you’ll be responsible for covering the difference.

Let’s take a look at an example of how shorting works. Imagine that Company X’s stock price is currently $50 a share. You think this price is overvalued, so you decide you want to open a short. You contact your broker and say that you want to short 100 shares of Company X’s stock Your broker would purchase 100 stocks at $50 each for a total investment of $5,000. Your broker would then loan the stocks to you, and you would sell them immediately at $50 a share.

A few days later, a major scandal hits Company X, and its stock falls to $30. You use your $5,000 to repurchase 100 shares, spending $3,000. You pocket the remaining $2,000 and return the 100 shares to your broker.

Why would your broker allow you to sell stocks that it bought? Shorting offers a number of benefits to your broker, including:

● A guarantee on its stock return. Your broker can require you to close out of your position and return the stocks you borrowed at any time. If your stock’s price rises instead of falls, other traders may enter shorts. Your broker may require you to close out and pay the difference out-of-pocket.

● Paid dividends. If the stock you’re holding pays out a dividend during the time you’re borrowing it, your broker might require you to pay the dividend back to the broker.

● Paid commissions or interest. Your broker might require you to pay interest on the stock value you borrow or charge you a commission to complete your transaction. Your broker is guaranteed to receive this fee, no matter how much you earn or lose.

Shorting is a very risky strategy that can result in major losses. However, for the experienced trader, it can also be a vehicle for huge profits realized over a very short period of time.

Short Selling Rewards

Is shorting the right trading strategy for you? Let’s take a look at a few of the benefits of the short selling strategy.

Potential to Hedge Against Your Investments

When you hedge an investment, you offset or minimize the chances that your investment will lose value. Many professional traders use shorts to offset temporary losses if they make a bad investment. This allows them to earn back some of the money lost during a dip in value without closing their positions.

For example, let’s say you buy Company X’s stock because you think Company X has a solid financial foundation and sells a great product. However, a temporary scandal or political event has caused Company X’s stock price to plummet. You still believe in Company X — but every day, its stock is going down. If you think it will continue to go down, you can hedge your position with a short sale of more Company X stock. This will allow you to regain some capital without selling off your initial investment in Company X.

Potential to Earn Money in a Bear Market

A bear market is one in which prices tend to trend downward and investors are more cautious. It can be very easy to lose money holding stocks or day trading during a bear market, as prices have a tendency to drastically fall after small price improvements. Shorting is one of the few ways to earn money in a bear market — and if your bets are correct, you can see a large amount of profit in even the most negative market conditions.

Short Selling Risks

With massive potential for profit and a low barrier of entry, you might be wondering why everyone doesn’t jump into shorting — especially if the market is low. Short selling also comes with a number of risks as well. Let’s take a look at what you might lose if the market isn’t on your side.

No Limit on Loss

When you invest your own money in a stock, the worst possible case scenario is that you lose 100% of your initial investment. For example, if you buy 100 shares of stock for $10, the most money you can possibly lose is $1,000 — and that will only occur if the company you invest in goes bankrupt and the stock goes to $0.

When you short a stock, there’s no limit to the amount of money you can lose. If the stock you bought sees an immediate price surge, you can lose hundreds of thousands of dollars in as little as a few days or weeks. While most brokers will require you to close out of your position before you hit this level of loss, the truth remains — shorting is incredibly risky, and just one bad bet can leave you bankrupt.

Bad for the Market As a Whole

While shorting might be great for an individual investor to turn a quick profit, too many investors shorting can turn a normal price downturn into a collapse. If too many investors are betting that a stock will go down, it may cause an artificial sell-off, deflating the value of a company or asset past its natural point.

Some experts blame short selling for a portion of the 2008 financial crisis. An influx of short sale orders for Lehman Brothers Holdings caused a panic, as more and more sellers flurried to get rid of their shares, plummeting the price and eventually leading to the financial crisis. While it's unfair to place the entirety of the crash on the shoulders of short sellers alone, a large number of bets against the market did suppress share prices and help encourage a sell-off.

Short Selling Process

Are you ready to try shorting your first stock? Follow these steps to make it happen.

Do Your Research

Shorting is a very risky trading strategy — and you stand to lose potentially thousands of dollars if the price of the stock you want to short rises instead of falls. Before you even think about entering a short position, you’ll want to thoroughly research a variety of stocks and be sure that you’re choosing the right one.

Most traders use a mixture of two forms of analysis when they decide which stocks to short:

● Fundamental analysis measures the value of a stock based on company and industry characteristics. Fundamental analysis can include everything from a company’s history of financial management to its board of directors to the overall condition of the company’s industry and the economy as a whole.

● Technical analysis doesn’t attempt to quantify a stock or asset’s intrinsic value. Instead, a trader using technical analysis to evaluate a stock will look solely at the charting pattern of an asset’s price changes. Particular candlesticks or pattern formations may indicate that a stock is likely to decrease in value in the near future.

To begin, you may want to start by researching stocks in an industry you’re familiar with. Once you’ve found a stock that will fall in price in the near future, move onto the next step.

Set a Short Order

Open your brokerage account and set an order to “short.” If your broker supports stock shorting, you should see a “short” option in the same area where you would place a buy or sell order. If you don’t see a shorting option, contact your broker and request to place a direct short option.

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Monitor Your Position

Once your short is set and you have your position, monitor the price of the stock you’re shorting. Hopefully, it will decrease in value. If it increases in value, know when to close out and limit your losses.

Buy Back the Stock

When your stock price has fallen to an adequate level, enter a buy order for the number of shares of stock you owe. Most brokers will have an option to “buy to cover” on your brokerage ticket — this just means that you’re buying back stock to close out of your position and take your profit.

Once the buy to cover order is filled, the short sale is complete. If there is money leftover after your broker’s commission and interest, you’ll see it as cash in your brokerage account.

Shorting Your First Stock

If everything goes well, your buy to call order will be the end of your short sale, and you’ll see immediate profits in your account. However, if your stock’s price goes up and you don’t close out, your broker might issue something called a “margin call.” If you encounter a margin call, it means that your broker is requiring you to put more cash into your brokerage account to compensate for a position that’s losing value. If you fail to add more cash to your account, your broker may close your position for you and charge you for any losses incurred.

Shorting stocks can be very beneficial — there’s the potential for fast profits and it’s also one of the best ways to make money in a bear market. However, shorting is also very risky, and you can lose an unlimited amount of money on a short sale.

Before you decide to enter a short, be sure that you’re using the best broker possible. WeBull allows you to keep more of your profits by cutting the commissions. Open your WeBull account today — and get started on the road to better trades!

source: https://www.webull.com/blog/31-How-To-Short-A-Stock-Is-It-Worth-The-Risk