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Short Selling A Stock Explained

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Editor’s Note – Everyone is talking about GameStop, short selling, and what happened to the stock market on January 28, 2021. Today, we’re taking a step backward to unpack the complexities of short selling.

Currently, over half of all Americans over 18 invest in the stock market. Many of them do so as a way to make a living. Some, who have extensive investment experience and understand advanced concepts, make a killing.

Others treat it as an enjoyable hobby, and if they happen to net themselves a little play money along the way, all the better. There’s also a fair number of folks who fall somewhere in the middle, having built a portfolio as just one facet of their overall investment and savings strategy.

Whether you’re dipping your toe into the market waters on the recommendation of your financial manager or just want to dabble as a diversion, you have may have heard about short selling, also known as shorting a stock. Should you think about incorporating it into your investment activity?

Of course, there’s no clear-cut answer to that question, since shorting a stock is one of the market world’s more complicated maneuvers. As such, there are a lot of moving parts to understand. 

For now, however, you should know that there are times when shorting a stock makes sense. Read on to learn about the when, why, and how of short selling in the stock market.

What is short selling?

If the cardinal rule of real estate is “location, location, location,” then the investment equivalent is “buy low, sell high.” That mantra is only applicable to conventional “long” stock trades, however – when the investor buys a stock outright and then watches its progress with an eye toward selling once its value has increased (more on the topic of “long” versus “short” positions later).

Short selling is essentially the reverse of that strategy. It’s a way of profiting from stocks and other securities when they are going to drop in value. With short selling, the investor’s goal is to sell high and buy low—so when is shorting a stock is a good idea?

There are four basic steps of shorting. After researching a stock and determining that it is likely to tumble in the near future, the investor then:

  1. Borrows the stocks from a broker, for a fee.
  2. Sells the stocks for market value.
  3. Waits for the stocks’ worth to decline.
  4. Buys back the stocks to return to the broker.

If the investor has done their due diligence, and everything has gone according to plan, this trajectory results in a profit.

Essentially, short selling is a bet against a particular stock.

Long vs. short in the stock market

One of the fundamental concepts to learn about trading on the stock market is the difference between the terms “long” and “short.” In this context, those words do not necessarily refer to the length of time one holds on to stock before selling it again, as you might expect.

Instead, they have to do with the ownership of the stock in question and how its trade was initiated.

Unlike in regular commerce, in stock and options trading, it is entirely possible to sell a stock before owning it. This concept can be a bit of a mind-bender for the uninitiated, so let’s look at a music-related analogy.

Imagine that your sister wants to sell you a Fender Stratocaster guitar. You agree on a selling price of $1,000. Before you give her the money, though, you ask if you can borrow the guitar to start practicing for an upcoming gig. After all, you’ll need to tune the guitar, learn its peccadillos, and get a feel for its sound.

Once you get paid for that gig, you promise, you’ll write her a check for the $1,000.

Except, instead of taking the stage and playing, you turn around and sell the guitar to your buddy – for $1,300. You pay your sister, then pocket the extra $300.

Now let’s pretend that you borrowed the guitar without having a buyer lined up for it. Nor did you research how much money Fenders are worth before offering her the $1,000. Try as you might, you can’t find a buyer willing to give you that amount, let alone pony up any more money.

At last, your coworker says he will take the guitar off your hands for $700. Unfortunately, you’re still on the hook for that $1,000 to your sister, so you have just lost $300 in the transaction.

This is, of course, a VASTLY oversimplified example. 

With a short sale, you’re relying on the price of a particular stock to drop, rather than negotiating purchase and sale price yourself, as in the guitar analogy, and there’s no guarantee such a decline will occur.

Moreover, you aren’t just using the money received from selling the stock at market value to repay the lender. Instead, a short-seller actually has to repurchase the shares later – and it’s a gamble as to whether this will even be possible.

The investor who short sells a stock runs plenty of risks, including the risk that there won’t be shares available to buy back when, or even if, the price plummets.

Investing vs. speculating – two different approaches

Short Selling A Stock Explained - When Shorting A Stock Is A Good Idea - Investing vs. speculating - two different approaches

Why would someone want to short sell a stock?

Quite simply, people who engage in the practice of shorting are looking to make a profit. It’s important to understand that short selling falls under the umbrella of speculating rather than investing. Let’s take a quick look at the difference between these two approaches to better understand the motivation behind shorting.

Investors are – well, invested in the company they’re purchasing shares of. They have done their homework to learn about all aspects of the company, its mission, its competitors, and the overall climate of its industry. Moreover, this research has provided credible evidence that the company is poised to grow and become more valuable.

Investors tend to believe in a company on a more fundamental level. They would want the firm to do well even if they weren’t investing in it. Speculators, on the other hand, aren’t concerned with growth for growth’s sake, but only as that growth drives profit and makes the company – and by extension, its shares – more valuable.

Speculators don’t need to understand a company’s product or service thoroughly or feel any meaningful connection to it. They are only concerned with their financial position relative to the market.

In essence, even though both people are exchanging money for shares in XYZ Limited, the investor is buying part of the company, while the speculator is purchasing its stock.

Short sales are inherently riskier than long trades

When most non-investors think of the stock market, they imagine the type of trades known as “long positions” or “going long.” These trades occur when an investor purchases shares of a company and holds on to them, hoping that those shares will increase in value over time.

Naturally, time is a pretty broad concept, and in terms of the market, the duration of a long stock can be anywhere from a few minutes to several years. Ideally, the investor sells when they feel they can reap the highest possible profit. 

When you buy a stock or “go long,” you are betting that the company will enjoy a great deal of success, thereby accruing significant profits for its shareholders – the exact opposite of short sales.

Additionally, there’s an element of expectation at play that is trickier than other types of market investing. A short sale won’t be possible if everyone expects that stock to tank, because no one will be interested in buying it. The speculator who gambles that a particular stock is saleable, but will decline, is acting against popular expectation.

Furthermore, it’s a truism of the investment world that stock prices tend to rise over time. While there is plenty of short-term activity on the market in both directions, the overall trajectory tends upward. Shorting, then, is a bet against this established pattern.

The true relationship between time and trading approach

Short Selling A Stock Explained - When Shorting A Stock Is A Good Idea - The true relationship between time and trading approach

I said above that “long” and “short” don’t necessarily reflect a temporal relationship between the trader and the stock. However, in most cases, these positions do tend to align with the implied passage of time.

Going long on a stock is generally a long-term proposition – lasting months or years – at least when a buyer purchases shares as an investor. Conventional stock purchases can also be performed on a more speculative basis. One of the determining factors in whether the transaction can be classified as speculation or investment is the actual length of time between purchase and sale.

Similarly, short sales do often happen more rapidly, over days or weeks. That’s due to the fact that sudden market changes are what make short sales profitable – a sudden downturn in stock price after a quarterly report, as one example. Overall, shorting stocks works best in a bearish market.

When shorting a stock is a good idea

A savvy and experienced trader will theoretically be able to identify and seize opportunities for short-sale profits in any market. Yet there are some situations in which the overall market climate is especially amenable to this type of trade.

Overvalued stocks

Often, someone who accepts the risk of selling short does so because they believe the stock in question is overvalued. They must also have a strong suspicion that other investors will come to the same conclusion soon or that another occurrence will precipitate a drop in the stock’s price.

That event could be a poor financial performance on the company’s part or a breakthrough success achieved by a competitor. Other triggers that might influence the success of a short sale are virtually impossible to predict. There might be an unforeseen market development triggered by national or global events – a pandemic, for example.

A great way to find overvalued stocks is by using a broker that gives you a TON of data and research tools, like E*TRADE. E*TRADE was one of the first online brokers and is targeted toward more advanced investors. They give you a plethora of tools and resources to research stocks so you can quickly find an undervalued stock to short.

A bearish market

Shorting a stock is, statistically speaking, potentially more profitable during a down market. That’s especially true if the bear market here at home aligns with a global economic downturn – such as during the post-housing bubble and ensuing recession of 2008-2009 or in the first half of 2020 as the COVID-19 pandemic spread from Asia to Europe to North America.

Amid fears sparked by the novel coronavirus and its devastating impact on world economic markets, six countries in the European Union and additional Asian nations placed temporary bans on short sales.

In the United States, however, short sellers were given the green light to carry on by Jay Clayton, chairman of the Securities and Exchange Commission. 

By having access to advanced research tools and after-hours trading, you can increase your odds of cashing in on a bearish market. Webull is an excellent option for this, as it gives you not only access to tons of data on the stocks you want to short, but access to after-hours trading so you can make the most of your opportunities. 

Understanding the specific risks of shorting

Short Selling A Stock Explained - When Shorting A Stock Is A Good Idea - Understanding the specific risks of shorting

Any transaction that bears the potential for high rewards also involves a fair amount of risk, and that’s no different for short sales. Here are a few of the most common pitfalls to beware if you decide to give shorting stocks a go.

Unlimited loss potential

A short sale is almost always considered a more dangerous gamble than going long with a stock. Unlike with a traditional trade in which the buyer’s losses are capped at the amount of their initial investment, a short seller could lose more than 100% of what they invested. That’s because the price of a stock could conceivably keep rising, pricing investors out of buying back the stocks they borrowed.

Conversely, the profit potential of a short sale is limited. That’s why most financial experts recommend that novice traders hold off on attempting this type of transaction.

Fees and dividends

That brings us to a decided disadvantage: the substantial fees and dividends that the short seller must pay. When they first borrow stock to sell short, these investors must pay an agreed-upon fee to their broker. The typical fee for borrowing stock is 0.30% per annum, but it could climb as high as 20%-30% in certain circumstances.

Moreover, the short seller remains responsible for paying dividends to the lender until they return the borrowed securities. Should they decide to hold off on repurchasing the stocks because the expected decline hasn’t yet happened, the dividends and other payments associated with the stock must still be paid.

The short squeeze

Another potential peril of short selling is called a short squeeze. Imagine that the investor has completed steps one and two of the short-sale checklist, borrowing, and then selling the stock they expect to decline. Instead of its shares depreciating, however, the stock experiences a sudden and sharp uptick.

The investors are now forced to read the writing on the wall — this short sale has failed, and they will lose money, no matter what they do. The only question is how much or how little they stand to lose, and the faster they can buy back shares of the now-soaring stock, the less painful that loss will be.

Further compounding the problem, this rush of would-be short-sellers creates even greater demand for the stock, and its value spikes even higher.

A shortage of shorted stocks

The last disadvantage of shorting stocks that we’ll discuss is a seemingly straightforward one: when a trader attempts to buy back the stock they’re shorting, they might not be able to find it for sale.

This could be quite simply because no one is selling it, or it could reflect the precarious supply-and-demand created by short-sellers. After all, there might be many other traders who are trying to do the exact same thing and recoup their own losses. This point is especially true in a short squeeze situation, but it can also happen when the desired downturn of the stock value occurs.

Is short selling right for you?

Short selling is, at its heart, an unpredictable and risky venture. Its potential for commensurately high-yield rewards is what makes those risks tenable to speculators.

Short selling provides some fantastic benefits to investors in certain situations, however. It requires a low initial investment – the borrowing fees are the only capital you need to begin with since you are not yet purchasing the stock outright.

Shorting is also one of the only ways to continue making money during a bear market. That, as well as the fact that it makes a fantastic hedge against other holdings and potential losses, makes it a valuable tool for experienced traders.

Summary

Investors who are still getting their bearings may want to study the art and learn all they can about when shorting a stock is a good idea, along with other tips for maximizing profit using this method.

That said, as with any other type of investment or speculation, taking the plunge and learning through immersion is perhaps the most valuable, if not the easiest, approach to gaining experience.

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