An Education on Shorting Stock

Buy Low and Sell High. That seems to be the way to make money in the financial markets.

But can one reverse the process and still make money?

That is what this education is going to teach you.

The answer is Yes! If done properly and in the manner one needs to, money can be made by first selling the stock and then buying back later at a a lower price and pocketing the difference, (less the nominal fees on a percentage basis to execute this style of trading/investing).

Selling a stock you don’t own is called short selling or selling a stock short or ‘going short’

Other items can be shorted, such as futures and commodities. Even a derivative or stock option is an asset that can be sold short. For the purposes of this educational article, we are going to just talk about going short tock.

One must know the risks involved and the potential financial ramifications in doing this and your brokerage firm may not allow one to partake in this type of investing/trading without a certain amount of money in their account and / or a certain level of clearance in the account.

The Basic Premise

Sell a stock at one price in anticipation of the stock dropping in price where one can then buy it back ‘to cover’ at this lower price, pocketing the difference.

Example: Sell XYZ stock short at $50. XYZ drops to $45, and one buys it back to replace at $50, making $5 per share on that transaction, (less interest, fees, and commission).

For an investor to be able to trade short, their brokerage has to allow it and then must have the stock to lend, or they have to go find it somewhere to be able to provide the investor that stock to short.

This is because the investor/trader is ‘borrowing’ the stock or asset. And when one borrows they usually have to eventually give back what they borrowed. To do that the investor/trader has to buy back the asset at the current market price to replace that which they borrowed.

This is called buying back to cover. The investor/trade is buying back that which they sold to cover that original short sale.

The investor/trader is going to have to pay for the time in which it is ‘borrowing’ the stock when it is replacing it and that is where the brokerage charges what is similar to an interest rate to be able to do this.

Why Go Short

One would say the ‘No Brainer’ answer is ‘To make Money!’

I would agree that is why we are in the business of investing and trading in the financial markets, equities, options, both, or other asset classes.

But in order to make money there has to be a catalyst or reason why one takes the actions they do to make that money.

In short selling the catalyst could be any reason you feel would cause the stock to go down in price.

A reason could be an expected miss on their earnings announcement. Another is an anticipated non-approval of a biotech company’s drug. A potential lawsuit judgement against them where they have to spend money to cover the judgement against them. There are a number of reasons.

When to Consider a Short Sale? Whan you feel any of the reasons shown above as to ‘Why’ to go short a stock is going to happen. Earnings are pretty easy to anticipate vs the others as the earnings announcement date I given ahead of time. In fact, there are many websites out there dedicated just to highlighting and discussing when companies are going to announce earnings.

The Process

• One sees a stock they feel is going to trend down in price.
• They have a margin account, (yes a margin account is needed), approved for short selling and they go to that broker or broker site and place an order to ‘Short,’ ‘Sell Short’ or ‘Go Short’ x number of shares of stock.
• The broker(age) confirms they have the stock to lend, or they are able to go find that number of shares of stock (or as many as they can) to fill that order. Ata that time they are borrowing and then immediately selling the stock short.
• The short seller has to keep enough equity in the account to serve as collateral for the margin loan — at least 25% per exchange rules. The short seller should know how much their brokerage requires as it varies from broker to broker and even stock to stock.
• One can hang on to the borrowed shares as long as they feel they. They need to remember though, they are paying interest on those borrowed shares for as long as they hold them, all the while needing to maintain the margin requirements throughout the period, as well. If there is a dividend payout on that borrowed stock while they are hanging on to those shares, the short seller is obligated to pay that dividend to the lender – the short seller DOES NOT get that dividend.
• Regardless of where the stock price goes when the short seller or borrower has to or wants to return the stock they have to go buy it at the current market price to return it to the lender. 

• If the stock price falls, you’ll close the short position by buying the amount of borrowed shares at the lower price, then return them to the brokerage and pocket the difference as profit, (they should be mindful of the amount they’ll pay in interest, commission, and fees).
• If they have to buy to cover at a higher price than what they sold it short for they do so at that higher price to replace at the lower price losing the price differential times the number of shares of stock, (Another note her of being mindful of the amount they’ll pay in interest, commission, and fees).

Risks of Short Selling

I would be remiss in stating that one should understand the risks involved in short selling as there technically is an unlimited amount of money one can lose that isn’t just necessarily limited to the amount of capital one has in their account.

Let’s say an investor/trader has $50,000 in an account that is approved for shorting, (not saying there are brokers out there that allow shorting with a 50K account – this is just an example to teach).

If one shorts 100 shares of a $100 stock. They don’t own the stock, and they don’t have the rights to that $10,000 immediately. They have to wait until it is replaced or bought to cover.

They have to eventually replace the stock, and they have to go to the market at the current price to do so.

If that stock goes to 300 and they then have to replace the stock they have to go buy the 100 shares of stock at $300 per share or $30,000.  That’s a loss of $20,000 over the amount they brough in from the initial short sale.

Heaven help them if that stock goes to $700.  They have to bring in $70,000 to cover that trade, which is more than their account has. Hopefully, they would have realized that trade wasn’t working with the stock going higher sooner than all this to buy back to cover and at least break even.

Final Words

Short sellers are wagering that a stock will drop in price.

Let me remind you all that short selling is riskier than going ‘long stock’ because, technically, there’s an unlimited amount of risk.

It can be looked at as exciting and maybe sexy to do because a good amount of money can be made in a quick amount of time, because of how fast a stock can drop in price over how fast it gains, but…

If you are in this for that kind of a thrill, might I suggest one take up bungee jumping instead. You get the thrills with that activity and the only money you risk there is whatever amount of cash you have that may spill out of your pockets when you do.

Be aware, educated and know your risk before taking this type of investing/trading on before even trying it. Discuss this type of activity with your broker and determine its suitability for you and your portfolio before short selling.

Inexperienced investors may quickly find that short selling isn’t to their advantage.

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