Most all of us grow up with a fundamental and innate sense of optimism. We tend to feel good when things are just right, and conversely, in down times we collectively maintain a sense of "hope" that a better future lies ahead. For certain, the attitude is almost tangible throughout the halls of Wall Street. In the options market, the number of traders wagering on rising stocks (call buyers) clearly outnumbers those betting on the down side (put buyers), even in extended bear markets.
And while this innate sense of optimism may be good in a societal sense, trading accounts don't always benefit, especially for those stuck in "hoping" their stocks will go back up. No, reality - and prudence - dictates a wiser course.
We should already be aware that economic cycles have periods were various sectors fall in and out of favor. In down markets, contraction - complete with falling stock prices - ensues as a natural course of events. And for traders, it's imperative to recognize this contraction. We must immediately and decisively take action to protect profits, minimize risk, and plan for new opportunities. That's what this business is all about!
Today we'll focus on a few of the profit opportunities and tactics applicable to Short Selling. The idea is to remove some of the "mystery" surrounding this supposed "black art." It's our goal to arm readers with basic knowledge of this potentially profitable stock trading tactic. Be forewarned, however, that Selling Short, like anything else we'd like to excel at, takes practice, practice, practice!
Here's how it works. Most investors buy stock with the intention that it will go up in value. On the other hand, short sellers sell stock they DON'T own because they believe that the stock will drop in price. For those familiar with short selling, that last sentence probably made sense. But for those of you new to the idea of shorting, you are probably asking, "How do you sell something you don't own?"
Well, in order to sell shares that you don't own, you must borrow them from your broker, sell them, and then replace the shares by purchasing them at some point in the future - hopefully at a lower price. This is where the phrase "selling short" comes from. You are "short" the shares that you've sold. You don't own them. There are a few rules to keep in mind with this tactic.
1. No Shorting in IRAs
Shorting is not allowed in IRA accounts. One of the rules imposed on Individual Retirement Accounts is that you can't borrow within the account, or you risk having the account disqualified as an IRA. Therefore, for those of you who trade within your IRA account, shorting probably isn't an option under the current tax rules.
Second, dividends paid to you during the time that you are short a stock need to be repaid to the lender of the stock. The actual shares borrowed have since been sold to a new owner who receives the dividends for those shares. However, the lender is also entitled to dividends on the shares they lent, and it's the short seller's responsibility to make it up to the lender. Again, your broker's computer system will keep up with the details, but it's a good idea to be aware when dividend payments are scheduled.
4. Calling Your Shorts
Third, the broker who lent the shares that you sold short may ask for the shares back at any time, in which case you will have to buy shares to cover those you borrowed from him. A broker has the right and sole discretion to require a short seller to cover, even if it's at an inopportune time.
When you buy a stock long and it goes down instead of up, you have the option of waiting for it to recover over the long term. However, if you are short the stock and it goes up instead of down as you had planned, the broker that loaned you the shares could require that you cover them (meaning you'll have to buy them back NOW).
Fortunately, this doesn't happen that often, but it is still important for short sellers to use buy stops to avoid letting a trade move too far against them. Technically, the potential loss from selling short is unlimited because the stock price has the potential to go up forever. Of course, as one trader put it, "you would have to be in a coma to let something like that happen!"
When Should You Consider Shorting?
The RightLine Report regularly includes suggestions for short sales that are based on a variety of setups with strong potential for profits. For example, companies who issue earnings warnings or lower than expected results are often punished by disappointed shareholders who immediately sell the stock. There is a way to profit from the situation by shorting the actual stock, or an even larger group that we refer to as "sympathy stocks" that are in some way related to the company. When a company announces an earnings warning or reports less than favorable results, look to other stocks in the same industry group or sector to be dragged down as well.
Look To The Charts
Learning to sell short allows you to take profits when the market is going down. If you are accustomed to buying, or going long, on breakouts above resistance when the market is strong, you can apply the same procedure to shorting breakdowns below support when the market is weak. You may find it helpful to flip your graph upside down and look for breakout entry points. As always, increased volume confirms a trend - up or down. Getting used to trading "upside down" requires lots of practice, so be patient with yourself and use a smaller than normal position size while you are learning.
And don't forget those stops!
Just like with long plays, a complete trading plan includes the use of trailing stops to protect profits.
More on Shorting ...
Is there a downside to shorting?
The most common objection has to do with the so-called "unlimited risk" of shorting. The idea here is that if you place a short sale and then permanently ignore it, the stock could theoretically increase in price forever. As a result, you would accumulate greater and greater losses over time - hypothetically to infinity. When you compare this scary interpretation of "unlimited risk" to the "limited risk" of buying stocks whose value can only drop to zero, it seems like a reasonable argument against shorting. A closer look reveals the truth.
Basically, anyone who enters a position whether long OR short, then walks away and ignores it is asking for serious trouble. Every trade should be entered with a planned exit, and then monitored for performance. If the trade moves in the wrong direction, you have to get out. But let's suppose that someone DOES enter a short position and then just walks away from it. There is a limit to the amount of loss they may incur, for if the losing short-trade reaches a level that puts their margin status in jeopardy, the brokerage firm will attempt to contact the trader. If they get no response, the broker will close the trade to protect their margin.
Far more traders lose money in long trades than short trades. In reality short sellers tend to have better results because they have taken the time to learn how to trade both sides of the market. What this really means is that educated traders do better . . . period.
Can you short stocks long-term?
Although you can hold a short position for as long as the stock is available to borrow, shorting has recently been primarily a shorter-term strategy. Some rules do apply, so see your broker for details. Shorting in a non-trending or up-trending market can be difficult. When bad news or sector rotation takes a stock out of favor, the company and brokers do everything in their power to buoy the stock. Most investors want the market to move higher. They invest in the hopes that individual stock prices will go higher as well. Only shorters hope that stock prices drop, and shorters are relatively few in number.
Companies release positive news stories and brokers do their infamous upgrades. These actions become forces that tend to drive the price back up in a bull market. In a bear market, it doesn't matter what brokers or companies say - they rarely have the power to drive stock prices back up for very long.
Why would someone want to loan their shares to a shorter?
Well, the truth is that shorting generally takes place without the stockholder's knowledge. Under certain conditions stockholders can instruct a broker not to allow their shares to be shorted, but this is rarely done.
Why would a brokerage want to allow shorting?
Because brokers make a commission on the transactions. The shorter pays a commission to sell short AND to buy to cover. In addition, the person who buys the shares from the shorter pays a commission for the purchase. It's all about the money!