How To Short Stock
What Is Short Selling?
So what is short selling if you actually profit from the stock price going down?
Short selling (or shorting), is when you ‘borrow’ stock, sell it, then at some time in the future buy back the stock and return it to the ‘lender’. If the buy price is lower than the sell price was when you borrowed it, it will cost you less money to buy it back. This means you will have change left over from the whole transaction.
This ‘change’ you have left over is your profit from the short sell.
To put an unlikely analogy to it to make it easier to understand: You borrow your friend’s watch and sell it to a shop for $1000. A week later you hear the shop is having a 50% discount sale, so you go back in there and buy the watch back for $500. You return the watch to your friend and pocket the difference. You have effectively (and unwittingly) just shorted your friend’s watch and made $500 from the short.
Is It Wrong To Short Stock?
I am a trader and as such play the stock market to make money, period. I don’t grow emotionally attached the companies I invest in. I get in, I get out, I make money. It’s just a mind set I like to be in to detach myself emotionally from what I am doing. We go into more detail about the importance of this in trading in the ‘Trading vs Investing‘ article on this site.
I have the same mentality with shorting. I use it to make money only and don’t think that what I am doing is morally wrong. I feel I have to say this because many people do think shorting stocks is morally wrong. After all you are hoping that the stock price will fall, perhaps almost willing it to fall.
If I have my hard earned nest egg riding on the successes of any particular company I would not want anyone willing the price to go down. This general attitude towards short selling has even lead governments of some countries to forbid it on their markets.
Who Do You Borrow Short Stock From?
Basically you borrow from the ‘pool’ of margin liquidity in the stock market which is accessed on your behalf by your broker or online trading platform. No one person will ‘loan’ you the stock, in reality you are only borrowing it on paper. The process is instant and done electronically.
Of course you need to have the money in your account to short stock, this effectively guarantees the loan. If you shorted $1000 worth of stock you need to lock in $1000 from your account to make the order.
Is Shorting Stock High Risk?
Certainly that’s what the general consensus wants you to think. In reality, no, it is no different from normal (going long) trading. In fact in some ways it is much better than normal trading. We will discuss this later.
The reason the general consensus thinks that shorting a stock is high risk is because the price of a stock can go up forever. If it did then you would be left owing millions.
Whilst this is not entirely true (your broker would liquidate your trade as soon as it hit zero value), it’s true enough to reiterate the importance that when shorting stocks you must use stops.
Using stops (stops for loss and gain) is probably the most important rule in trading, and this is even more so when shorting.
There’s a great little strategy which uses automatic stops almost exclusively in its trading. The principal is the same with short selling. Check it out at besttradingstrategy.com.
Is Shorting Stock More Profitable?
By definition it is no more or less profitable than going long. If a stock goes up $10 or down $10 you make the same amount from the trade whether you bet it goes up or down. The risk too is the same (notwithstanding the backgound market direction).
One thing which does happen which is in favor of shorting is the time in which it takes the stock to move. It can take several weeks or months to rise 10%, but it can lose 10% in days if not hours. This makes for very quick profits. You are in and out in far less time and are therefore in a position to make more trades.
What Are The Best Stocks To Short?
Most brokers and trading platforms will only allow you to make short sell orders on the larger cap stocks which have more liquidity around. You can’t short penny stocks unless you have a very big account with your broker, and many industries are off limits to short selling.
There are still many thousands of stocks to choose from which you can short, so you won’t be restricted on choice, however I would recommend you go for those ‘basket stocks’ like the QQQQ.
These special stocks like the QQQQ are made up of 100 industry specific companies (like a mini-index) which can be bought, sold and shorted just like normal stocks. They are far less volatile than single stocks and there is no chance you will see them shoot up in value quickly leaving your shorts short changed.
How Do You Make A Short Order?
To short sell a stock you make the order with your broker like you would with any order, just say you want to short sell it. If you have an online trading platform (as you should) then you can choose ‘Short Sell’ instead of ‘Buy’ in the order control center.