When most people buy an investment like a stock, they're hoping for the stock price to go up. If the stock price is lower when they buy the stock than it is when they sell it, they've earned a profit. This process is called "going long." Selling a stock short, or "shorting" as it's colloquially known, is the opposite. Instead of betting that the price of an investment is going to go up in the future, people who short are betting that the price of an investment is going to go down in the future. How do you do this, and how do you make money doing this? Read this tutorial to find out just how to sell short.
Steps
Understanding the Theory
- Bet for the price or value of an investment to go down in order short sell. As mentioned above, shorting is the opposite of going long: Instead of betting that an investment is going to rise in value over the near- or long-term, you're essentially betting that the investment is going to fall in value.[1]
- Investors who go long want to buy low and sell high in order to maximize their profit. This is one of the maxims of investing. Investors who sell short essentially want to do the same thing, except in the reverse order.[2] Investors who choose to sell short want to sell high and buy low.
- Understand that you technically don't own the investment that you're going to short. When you place a trade to sell short, your broker will lend you a stock, for example. Immediately, the shares of the stock are sold and placed in your account. You wait for the stock price to drop, at which point you buy back the same number of shares you originally sold. (This is called "buying to cover.") The difference in price between what you sold first — although you technically didn't own it — and what you bought later is your profit.
- Look at an example to aid in comprehension. Let's say that you, the investor, want to short a 100 shares of XYZ Company stock currently trading at $20. You contact a broker, who loans you 100 shares of XYZ, which you immediately sell. You now have $2,000 credited in your account, although the money is frozen because you don't own the stock and will eventually need to buy the stock back.
- You wait for the price of the stock to drop, because selling short is a bet that it will. After a disastrous Q3 earnings report, the stock price of XYZ Company plummets to $15 per share. You buy 100 shares of XYZ Company at $15 to cover your initial bet, returning $1,500 to the person you borrowed the money from initially.
- Your profit is the difference in the price of the investment when you sold and when you covered. In this instance, you sold XYZ Company stock at $2,000 and covered at $1,500. You made a profit of $500 by shorting XYZ Company stock.
Knowing the Risks of Short Selling
- Be prepared to pay interest on your short bets while you wait to cover. Usually, you can hold onto a short position for as long as you want. But because you're borrowing the stock from a broker or bank, you're going to have to pay interest on your position. The longer you hold onto the investment, the longer you pay interest on it. You didn't think you'd just be given free money, did you?
- Be aware that some short investors are "called away." Sometimes, an investor trying to short a stock is forced to cover before anticipated because the broker that lent them the stock wants to sell. Remember that you don't own the stock you're trying to short; you're loaned it by a broker. If that broker wants to sell the stock before you do — because it's an opportune time for them to make money, usually because the price is higher instead of lower — you may be forced to cover an unfavorable position and lose money.
- Although being called away doesn't happen often, it's not unheard of. Being called away happens most frequently when a larger numbers of investors are all trying to short a particular stock.
- Know that shorting is much riskier than going long. When you go long, you bet that the price or value of an investment is going to go up. If you buy 100 shares of JKL Company at $5 per share on a long position, the most you lose from your investment is $500 — if the stock price falls to $0. The most you can gain is, well, unlimited, because there's no upper limit for how high a stock price can go. In other words, there's a limited downside and an unlimited upside.
- Selling short is — you guessed it — the reverse: There's a limited upside and an unlimited downside. When you sell short, be prepared to deal with the possibility of "unlimited losses," as it's known.[3] You can only profit in proportion to how low the investment drops, which is finite; you lose money, however, in proportion to how high an investment rises, and investments like stocks have potentially unlimited share prices.
- Make sure time isn't working against you. Long bettors often hold on to their investments for significant periods of time, waiting for the opportune moment in which to sell. Some investors hold onto stocks for their entire lives.[4] [5] Short sellers often don't have that luxury of time. They often need to sell and then cover very quickly. Because they borrow their positions from brokers, they're working with borrowed time.
- If you do decide to short sell, be reasonably certain that the price of the stock is going to fall reasonably quickly. Set yourself an artificial deadline with a buffer period. If the stock hasn't fallen significantly after the artificial deadline and the buffer period, re-evaluate your position:
- How much are you paying in interest?
- How much have you already lost, if any?
- Do the same circumstances that caused you to bet the stock was going to fall still hold?
- If you do decide to short sell, be reasonably certain that the price of the stock is going to fall reasonably quickly. Set yourself an artificial deadline with a buffer period. If the stock hasn't fallen significantly after the artificial deadline and the buffer period, re-evaluate your position:
Diving Into the Nitty-Gritty
- Before you put any skin in the game, research the investment's vitals. Selling short, like going long, is an investment. And people who make smart investments usually invest for a reason. Have a good idea of why you think an investment is going to turn sour. Marshall any and all information that you can find that either vindicates or discredits your position. Don't go into the research phase expecting to short; decide to short after the evidence tells you it's a good idea.
- Stocks: When looking at stock market vitals, pay special attention to expectations of future earnings. This is the most important factor in determining a company's stock price. While future earnings are impossible to predict exactly, they can be "guesstimated" with the proper information.
- Bonds: Because bonds are a security, they can be sold short if desired. When deciding whether to short a bond, look at bond yields. Yields which are closely tied to interest rates. When interest rates go down, bond prices jump; when interest rates go up, bond prices fall. An individual shorting a bond would want interest rates to go up and bond prices to fall.[6]
- Research the company's "short interest" before deciding to short. A company's short interest is the percentage of outstanding shares that are being shorted. In other words, a 15% short interest means that 1.5 investors out of 10 currently hold a short position on a particular stock.
- A high short interest usually indicates that investors think a particular stock or bond will drop in value. It's probably a safer bet to sell short on a stock or bond with a high short interest, although it's always risky to buy into hive mentality.
- On the other hand, a high short interest also may make the price of the stock or bond more volatile. This can cause a larger swing in prices than some investors are used to.
- Know that short covering can temporarily boost the price of an investment. This is an unintended consequence of short selling. When you short a stock initially, for example, the stock price goes down because you're effectively selling shares. When you buy the stock back in your cover, the stock price rises. If many people who are shorting a particular stock decide to cover at the same time, the stock price may rise dramatically. This is called a "short squeeze."[7]
- Know that while you're holding a short position, you are responsible for paying out dividends, and must cover any splits that happen. Stocks issue dividends to its shareholders, which is another benefit of holding a long position. If shorting a stock, you must pay the lender of the stock any dividends paid out during your holding period.
- If a stock splits, you are responsible for paying twice the number of shares at half the price. The material position of the investor is not fundamentally changed by a split; just keep in mind that when you cover, you'll buy back twice the original shares.
- Use short selling as a portfolio hedge, not as speculation. If you're using short selling to speculate, you're probably using short selling in an unnecessarily risky way. Instead, use shorting as a hedge against big losses. Like futures, shorting can be an effective may to distribute risk across many different scenarios. If practiced recklessly, shorting can lead to dramatic losses.
Tips
- Keeping a short sale open for a long time will cost more.
- Pay attention to the short interest for the stocks you want to short. If too many people try to short a stock, it may go on the hard-to-borrow list. If this happens, you may have to pay extra to short the stock.
Warnings
- If the lender wants the stock you borrowed back, you'll have to come up with new shares to borrow, or you'll have to cover.
Sources and Citations
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from How to of the Day http://ift.tt/1skuH3V
via Peter
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