Different Types of Short Selling: How to short sell stocks.
What does short selling mean?
Also known as shorting. It is borrowing a stock from a broker, selling it to a buyer with the hope you’ll repurchase the security at a cheaper price. This is unlike going long where an investor buys a stock and later selling it at a higher price.
Different Types of Short Selling
There are two main types of short selling – naked shorts and covered shorts.
Naked short involves short selling an asset or stock without first borrowing from an individual. Often, the short seller will not enquire whether the asset can be borrowed. Naked shorting is prohibited in several markets such as the Hong Kong and the U.S. stock market.
If the seller does not obtain and deliver the asset to the buyer within the specified timeframe, a situation referred to as Failure To Deliver (FTD) comes up. As such, the trade will remain open until the seller delivers the asset to the buyer.
Naked shorting also affects the liquidity of a company’s stocks. Short sellers might sell non-existent stocks and once other investors get interested with the stocks, the demand will rise. Unfortunately, this growing liquidity will only increase chances of FTD.
Following the 2008 financial crisis, the Securities and Exchange Commission (SEC) banned naked shorting in the U.S. This is after financial giants Bear Stearns and Lehman Brothers filed for bankruptcy.
On the other hand, covered short is when the seller borrows a security from a broker. Later, the seller will repurchase the stock or asset. This act of repurchasing the asset gives it the name covered short. Ideally, the investor is covering their short position.
How to short a stock
To start short selling, you’ll need a margin account. You’ll also pay interest on the stock’s value. Besides, regulatory body Financial Industry Regulatory Authority (FINRA) requires you to have a minimum amount in your margin account. This amount is referred to as the maintenance margin. If the maintenance margin is below the set limit, your broker can sell your position.
As a short seller, you are predicting a stock value will fall. And since you don’t have the stock, a broker can lend you if it is available. Should the price decrease, you’ll buy the stock at a lower price pocketing the difference. In short, you are selling high to buy low.
Here is how you can short a stock:
Find the stock
First, you need to find a stock that is likely to decline in value. You can use fundamental or technical analysis. Some of the fundamentals to look for include bad earnings, debts, lawsuits, and others. Ideally, you should distinguish whether the events and short or long-term to avoid making mistakes. If using technical analysis, look out for overbought and weak longs.
Place a sell order
After identifying the stock, it is time to place a sell order. Remember you are selling a stock you don’t own. Fortunately, brokers cannot tell if you own or don’t own the share. As such, you’ll place it just as you would a normal sell order. You should sell a negative sign before the stock in question.
Wait for the price to dip
After placing the sell order, you’ll wait for the price to fall. Like other orders, you can choice the position at which to close the order.
Buy the stock
If the price movement favors your prediction, you should buy the stock and close your position. Your profit – what you’ll pocket – is the difference between the selling and buying price.
Why short selling?
Well, you short sell a stock if you are convinced the price will dip within a specified timeframe. Other investors will short sell a stock for speculation or hedging intensions. Since losses in short selling tend to be huge, most traders will short sell over a short timeframe.
Those who short sell for hedging purposes do so to protect their profits especially if they own long positions. Also, short selling enables them to mitigate losses if they do not want to exit their long positions.
If you want to reap huge profits, you can short sell a stock. Besides, short selling requires less capital since it is purely on speculation.
Another reason traders short sell is to provide market liquidity. This pushes stock prices further down enabling swift price recovery. And with short selling, you can reduce volatility of your portfolio since you can use long and short positions.
Example of stock short selling
Let’s say an investor wants to make a profit from company X stocks selling at $20. The trader speculates the price will dip in the next two months. As such, the investor borrows 100 shares from a broker and sells them to another trader. In the trader’s account, it will read –x100 shares.
Come the end of the month, the company reports bad financial results. As a result, the stock price dips to $5. To take advantage of the situation, the trader closes the position and buys the 100 shares at the current price. The investor will have a profit of $1,500.
Conversely, the price movement might not favor the trader. In this case, he or she will make a huge loss. For example, the trader might speculate the price will dip to $3 so he leaves the position open. However, a peer company comes to the rescue of company X.
Suddenly, the stock price rises past $20 hitting a high of $40. This means the trader makes a loss of $2,000.
Best short selling strategies
Selling a pullback in a downtrend
A pullback is a brief change in price movement. At this point, traders are unsure about their next move. As such, the price stalls for a moment. Most traders will therefore speculate a continual of the uptrend. However, a pullback indicates price reversal and as such, you should consider selling stocks.
Selling during an active downtrend
Often, if the price of a stock declines and closes below the opening price, a price decline is imminent. While rightly so, the cause behind the price dip can change. This means you should sell when the downtrend is active.
Only short sell in a bearish market
To avoid huge losses, you should limit your short selling to bearish markets. Besides, bear markets are not as common as bull markets. This means short selling in a bull market will definitely lead to huge losses since you are literally swimming against the current.
Use stop-loss order
Often, you’ll run into a stock whose fundamentals are amiss. However, its value continues to rise pushing prices way higher than expected. As a result, traders buy more stocks to cover their borrowed ones. This creates a huge gap that only a stop-loss order can come to a trader’s aid.
Common risks short sellers face
This is arguably the most common risk short sellers face. It happens when the price of a heavily short stock rises quickly. This triggers the traders to buy the stock to cover their trades. As a result, other traders buy the stocks pushing the prices further upwards. Such is the case with the GameStop, a USA-based game retailer. Early 2021, traders heavily short its stock causing a short squeeze that saw its stock price rapidly rise.
Another risk is relevant bodies banning short selling activities. They do so to mitigate obnoxious selling pressure. This can lead to sudden price increase leading to short sellers buying the stock at a high price.
Going against the norm
Most stock prices curve an uptrend as the company grows year on year. This means short selling is going against a known and proven trend in the market.
Is short selling right for you?
While short selling allows you to make profit with minimal capital, it comes with its share of disadvantages. They include:
· It can be expensive to borrow a stock that is less liquid. And should the price movement go against your speculation, you stand to incur huge losses.
· Since most stock prices register an uptrend over time, it is hard to find a stock that has a well-defined downtrend.
· Although a rarity, stockbrokers can recall a borrowed stock leaving you with limited control to cover your position.
· In case of short squeezes, many short sellers will buy the stock to cover their positions. As such they can drive the price higher against other short sellers.
· Again, should there be less supply of a given stock, brokers can be reluctant to lend it to short sellers.
· Finally, regulatory bodies can ban shorting stocks when the market is volatile.