Short Selling a Stock
One other thing to rememberThis page is intended to help new traders understand what it means to short sell a stock. This concept is very different form the normal buy low and sell high mentality that is most common is trading stocks. Short selling is considered a very high risk trading strategy and should only be done by seasoned traders due to the unlimited potential for loss.
Understand sell short and buy to cover orders
The traditional way of making money on a stock is to buy low and sell high. When you sell short, you do just the opposite with this strategy. You first sell shares you don't already own (which you borrow from your broker), and then you buy them back later (hopefully at a lower price). There are certain risks when you sell short, and it is important to know what they are before you place this kind of trade.
There are some rules involved with this; for example, your broker must have the shares you want to borrow. In addition, you might not be able to sell the shares short while the price is going down (i.e. the stock's price has to be neutral or going up, if subject to what's called up tick or zero plus tick.
You must have a margin account in order to place short sales. When you use margin, you are borrowing money from your broker based on the value of the cash and securities you currently have in your account. You're charged interest on the amount you borrow; and the holdings in your account act as collateral to secure the loan. You can hold the shares short as long as you meet the margin requirements for the position, and your broker is able to continue to borrow the shares.
When you are conducting these types of transactions, you will need to enter a "sell short" order to "open" the position, and a "buy to cover" (not a regular buy) to "close" the position. The buy to cover effectively returns the borrowed shares to your broker.
The time it takes for your order to execute depends on a number of factors including the market activity, the price settings, and term limits you set.
Understand the risks of selling short
When you buy a stock outright, and the stock price drops, the most you can lose is the amount you originally invested. When you sell a stock short, however, your losses are theoretically unlimited - the higher the stock goes in price, the more you could potentially lose.
In addition, whenever you sell a stock short, you must have enough funds or margin buying power in your account at all times to place a buy to cover order if necessary. Otherwise, if the stock moves against you, you can find yourself borrowing money on margin for this purpose, and can be placed at risk of a margin call.
Understand SEC and NYSE uptick rules for short sales
You can’t sell shares short while the price is going down. The stock’s price has to be going up, what’s called an uptick or zero uptick.
Here's how it works. If the last three trades of XYZ are at 51, 52, 52, a short sell could be executed on the first trade at 52 (an uptick). The second trade at 52 would represent a zero-plus tick.
These rules are designed to keep investors from short-selling a stock which is already falling in price, thereby accelerating the stock's downward price movement.
Nasdaq/OTC stocks can be sold short only on an uptick - the price must be higher than that of the previous trade.
Important note that most short sellers find out the hard way. If you are short a stock at the market close the day before the so called “ex dividend date,” you will owe the dividend. This means that it will be deducted from your trading account and paid to the person who actually owns the shares. For example, say you own 100 shares of company XYZ, and then company XYZ declares a dividend of 14 cents per share, you will need to pay out $14. Doesn’t seem like a lot, but if you borrowed 10,000 shares or something near that of XYZ, it becomes a very big deal.
*If you still have questions please feel free to contact me directly and I will do my best to help you gain a better understanding of selling short in a stock trade. Also you may click the following link to GoodeTrades.com to view what my friend Micheal who is a most excellent trader and stock picker, has to say on "How to Borrow Shares to Short".
When you buy a stock, the worst that can happen is that the stock goes to $0 and you lose the money you invested in it. When you short sell a company, you can lose much more. Say you short sell XYZ at $10 and then it goes to $30, you have lost more than what you put into it. This is much different from when you buy a stock at $10 and it goes to $0. A stock will never be worth less than $0.
It can be very difficult to find shares to short of a specific stock. Many times, you have to reserve the shares or short it a little early since the shares most likely won’t be available when you actually do want to execute a short sell.
Be careful to pick stocks that have enough liquidity. This goes for both buying and shorting stocks. The lower the liquidity, the harder it is to get in or out of a position. Remember, when you buy, someone has to sell and vice versa.
You will need to have a margin account in order to short stocks unless you have a very large account, which means you may have to put up slightly more capital than if you were just planning on buying stocks. The amount of money you need to open an account will vary based on what broker you use.
You may experience a trader’s nightmare which is the dreaded "margin call". This means that you need to put more money into your account or your brokerage firm will sell off stocks in your account to cover you borrowed shares or buy them for you to cover the spread, always means you have fairly large losses in your account. When you use margin, you are basically taking out a loan from your broker. If you do not put up more money into your account, the trade will be automatically closed and you will no longer be able to do any trading for a certain amount of time.
The dreaded short squeeze. This is another short sellers’ nightmare. If there are a lot of buyers that come in all at once, for whatever reason, the stop will shoot up in price. This could happen when a stock has a large number of shares shorted and good news is released. People will be rushing for the exits and others will be trying to buy up the shares like crazy. This is also typical on Friday afternoons, as many people don’t like to be long over the weekend. As a short seller, you’ll inevitably experience this at some point. Just follow the rule of cutting your losses quickly.
Make sure you know how to exit your short stock position before you even think to enter into a short sale in the first place. When you short a stock, you will need to “buy to cover” when you want to exit the trade. Sometimes people make the rookie mistake of filling out the trade order form incorrectly and when its time to cover you something like not know what to do will put you in panic mode.
I never uses stop losses, but that is also because I would never enter into a short sale if I wasn't able to watch the trade closely. If you plan to leave your computer for a fair amount of time after you enter a short position, I highly recommend using a stop loss. If you don’t, you risk the stock rising rapidly and losing far more money than you ever thought you could. A stop loss will automatically exit you from the position if the stock reaches a certain level. Why don't I use stop loses? It is because of stop loses that we see short squeezes and rapid jumps in price as they each drive the price up and which in turn triggers the next stop lose. Besides, stop losses are not fool-proof.
Have a plan before you execute any trade but especially short sells. Trading anything means you should have a PLAN before entering any trade! This is extremely important and one of the keys to becoming a profitable trader. I don't know how so many people think they will earn a lot of money trading stocks without having a firm plan before they enter their trades. (Go to the Better trading by Training your long term memory page for help with this issue. Don't worry it's still free of course.)
The plan should remind you why you shorted the stock, what your target price for the stock is, and at what price you should exit your position. The video that is tied to that link will help you learn not to let your emotions get in the way of sticking to the plan. Like everything in life trading stocks long or short has a learning curve. Study, research and plan before you jump in unless you want to be counted in the 90% of traders* who lose money in the stock market every day.
*Unfortunately, a very large study of day trader performance showed that even more than 90% of day traders lose money in the long run. The study was published in 2010 of hundreds of thousands of day traders from 1992 to 2006:
https://faculty.haas.berkeley.ed...
This study showed that less than 2% of traders were profitable net of all fees.
In fact:
40% of day traders quit within a month
87% of traders quit within 3 years
93% of traders quit within 5 years
I cannot say whether you will be or maybe are one of those who will be profitable in the long run, or one of those who will be forced to quit soon. But it would be prudent to proceed with caution, study and ensure you have very robust risk management measures (a plan) in place.
https://faculty.haas.berkeley.ed...
This study showed that less than 2% of traders were profitable net of all fees.
In fact:
40% of day traders quit within a month
87% of traders quit within 3 years
93% of traders quit within 5 years
I cannot say whether you will be or maybe are one of those who will be profitable in the long run, or one of those who will be forced to quit soon. But it would be prudent to proceed with caution, study and ensure you have very robust risk management measures (a plan) in place.
