Being able to successfully short sell a stock is a very valuable trick to have in any investors pocket. If you want to learn how to do this then carry on reading.
Any stock that sits on the market can move in one of two directions, down or up. When the price of a stock goes up, investors make their money buy selling them at this higher price. This activity is called stock buying and selling. However, a different way of trading is short selling.
Knowing how to do this successfully expands the number of ways in which an investor can profit from day trading. Although it sounds difficult, and different from what you may be used to, once you learn how to do it, it can quickly become like second nature. It also means you can make a profit no matter if the price of a stock goes down or up.
Investing in the stock market
Having a long position on a stock is the exact opposite of having a short position. When an investor goes long, they buy a share at a certain price because they think that the price of the stock will go up. If it does go this way, as anticipated, the investor can then sell the stock at a higher price than they bought it for, and thus make a profit.
As previously explained, having a short position is simply the opposite of this. It means that the investor is guessing that the price of the stock will go down over a certain time period. This trading strategy takes a lot of practice, but is not quite as risky or as difficult as lots of investors believe it to be.
How to short sell
The process of short selling a stock begins with you borrowing the stock from the brokerage firm that you have your account with at a specific price. If / when the price of the stock goes down, you then buy them back, thus making a profit.
Here is an example; your research and analysis of the markets suggest that stock XXX will go down in price at some point in the future. Each share of the stock is trading currently at $25. You place an order with your brokerage firm with a request to sell 100 of these shares. They sell them and put the $2,500 into your account. It is important to remember at this point that the shares are just borrowed. When the price of the stock goes down, you buy the shares back at $10 each. This means you only have to spend $1,000 to do so and return the stock to the brokerage firm. This leaves the trader with a profit of $1,500.
If you have read this and think that it all sounds very simple and straightforward, then no doubt you will be asking yourself if you should try your hand at short selling. It is safe to say that this trading strategy is not for everyone, but some traders do make serious profits from the markets going down.
In order to begin short selling, you must first set up a margin account via a brokerage firm. This allows you to borrow from a broker in order to begin trading. Although margin trading (trading with a stock that you do not own) is an activity that many investors look down upon, it can be helpful when you are wanting to short sell a stock. This is why speculators in particular partake in short selling.
As well as having a margin account, you also need sufficient funds so that you are able to cover the losses which you may make. This is why it is important to understand what your level of risk tolerance is, both forward and backward, and to remember that the stock can go in either direction.
How to successfully short a stock
Below are the steps you must follow in order to be successful at short selling stocks. These include:
- Creating a margin account – A margin account can be opened with any of the major brokerage firms. Some might require you to answer some questions relating to what your trading strategy will be and what your goals are.
- Entering an order – This is a relatively straight forward process. You simply need to tell the brokerage firm which particular stock you would like to go short on.
- Maintaining a minimum amount of equity – A minimum of $2,000 should be kept in your margin account at all times. This is a requirement and is in place to protect the brokerage firm should you incur losses that you are unable to cover.
Shorting an option
Lots of investors short sell stocks with an option. This is a smart move as it may reduce the potential for loss, whilst at the same time increasing the potential for profit. This is a rare thing in the world of stock trading. Using an option to short a stock is a process named putting an option.
Putting an option means betting that the price of the stock will go down, whereas calling an option bets that the price will go up. Trading options gives investors the right to make a trade before the end of the contract.
Here is an example of this; you place a put option on 1,000 shares of a stock that is currently priced at $500. If / when the price goes down to $400, you have the right to exercise the put option you placed, and thus make a profit.
It is called trading options because as an investor you have the option of whether to exercise the trade or not. If the price of stock does not go the way that you want, then you have the option of not completing the trade. It may still be the case that you lose some money, but not near as much as you would in a regular short sell.