If you believe what goes up must come down in the stock market, you should learn how to short a stock. Stock prices fluctuate throughout the day, but trends are based on fundamentals.
When the fundamentals are bearish, there is potential to profit from falling stock prices. This is where short selling comes into play. Short selling is a risky endeavor and not suitable for everyone. In this article, we'll take a deep dive to answer the question, "What does it mean to short a stock?" and "How to short stock."
We'll cover the nuances and the safeguards to prepare you for the various outcomes so you can enter with your eyes wide open.
Key Takeaway
Shorting a stock means selling shares at a higher price and buying them back later, preferably at a lower price, for a profit. Short shares are borrowed through your broker and returned to the owner when you cover or close the position. Just as you may have reasons that a stock price will rally higher long term, you can also have reasons a stock will fall soon.
Understanding Short Selling
Let's take a minute to understand what it means to short sell stock. This can be a bit confusing if you are learning about short selling. Traditionally, investors buy stocks, which is a long position. They hope the shares will rise in value to profit from buying low and selling higher. If the stock price falls lower than where their long entry is, then the position loses money.
Short selling is the opposite. You are selling the stock first, also known as going short. You are hoping for the stock price to fall so you can buy back the shares to close out the position, also known as covering the shorts. The difference between the price you sold and the price you bought back is your profit. However, if the stock price rises, then you lose money.
Short-selling is riskier than going long because the losses can be unlimited. When you are long a stock, it can only fall to zero, and you lose your investment. However, when you sell short, the stock can rise indefinitely, causing your losses to mount to the point where you can lose many times your investment.
The Mechanics of Short Selling
While it may seem strange to sell a stock you don't own in your account, it occurs behind the scenes through your broker and clearinghouse. When you buy and own a stock, you usually don’t ask for the paper stock certificates to be mailed to your home. Instead, they stay in a digital format at the clearinghouse. This enables fast buying and selling as the shares are transferred digitally without shipping certificates by snail mail. The clearinghouses are the custodians that hold and transfer stocks.
Before you can sell short a stock, your broker must be able to borrow the shares. Not all stocks are borrowable, which makes them shortable. The stock must be borrowable to be loaned out for you to sell. Your broker works through the clearinghouse that holds the shares to get them to lend you the shares to sell. The owner of the shares doesn't know when their shares are borrowed. Some brokers have programs where stockholders can lend their shares and receive a fee. You can execute short sales once you have the shares on loan in your account. Short-selling blue-chip stocks in various sectors, like the consumer discretionary sector, help to ensure liquidity with less chance of a short squeeze.
Executing the Short
You would short sell the stock on the open market to execute a short trade. Usually, you can sell the stock at the bid or place it on the ask to get a better price. However, if the stock becomes short-sale restricted, you will have to wait for an uptick to short. This means you will usually place a limit order on the inside ask. Once the trade executes, you will receive a confirmation. Your account should show a negative stock position, indicating a short position.
Reasons for Short Selling
There are many reasons for selling short stock. They fall into two categories: fundamental and technical, like fundamental and technical analysis. Fundamental reasons are broad-ranging and have to do with any negative news, events, sentiment or information that can cause the stock price to fall. Technical reasons are strictly based on chart patterns and setups. A combination of fundamental and technical reasons can help comprise your thesis for shorting a particular stock.
Fundamental Reasons
Fundamental reasons are based on a company's financials, products, services, management, news, judgments, competition, rumors and virtually anything that doesn't have to do with charts.
A bearish macro market sentiment, sector weakness or a potential black swan event can be valid fundamental factors. For example, if XYZ reported a weak quarterly earnings report and lowered its full-year revenue and earnings forecasts, this could be a short-selling opportunity.
Technical Reasons
Technical reasons solely pertain to bearish chart patterns and setups for stock shorting. Technicians believe that the chart patterns tell the true story of a stock since they represent the actual buying and selling of shares. Charts are like the footprints left behind by dinosaurs. Traders understand that dinosaurs can’t walk in the sand without leaving footprints. Stock prices move solely based on the buying and selling demand. Here are some bearish technical patterns considered for short sellers:
- Bear flags: Bear flags are formed after a steep price drop forming the flag pole. The stock bounces in a parallel channel rising channel forming the flag. The breakdown occurs when the stock falls back under the lower flag trendline.
- Head and shoulders: Head and shoulders comprise three peaks and a neckline trendline. The first peak forms on the first high that shapes the left shoulder and pulls back down to form the neckline when it bounces again. The next bounce surges higher through the left shoulder level to form an even higher peak: the head. The stock pulls back again and bounces to continue the neckline. The next bounce rises to a lower high, forming the right shoulder.
- Inverse cup and handles: Inverse cup and handles are formed when a stock makes a bottom and bounces until it falls back down to the same bottom level again, forming the cup lip line. The handle forms on a shallow bounce that falls back down through the lip line, triggering the breakdown.
- Descending triangles are comprised of a descending (falling) trendline, which represents low peaks (tops) on bounces, and a flat-bottom trendline meeting at the apex. The breakdown occurs when the stock falls through the flat-bottom trendline.
In the daily candlestick chart of HRL, the descending trendline forms at the $32.73 peak as shares cascade lower. Each bounce attempt peaks at a lower high. The flat-bottom trendline at $30.15 is formed by the multiple bounce attempts at that level as bulls attempt to deflect breakdowns.
Eventually, the descending trendline and the flat-bottom trendline get closer to meeting at the apex point. A breakdown triggers ahead of that when the stock collapses under the $30.15 flat-bottom trendline, sending shares to a low of $28.51.
How to Short a Stock in 5 Steps
First, you must have a margin account with an online broker.
Step 1: Research to identify a viable short-stock candidate.
You may already have a stock in mind to short. You can also use a stock screener or a list of stocks to short on Marketbeat to search for potential candidates. Be sure to do your fundamental research and your technical research. It involves developing a thesis on why you believe the stock price should fall.
For example, you may believe that AI investments are overvalued. Be aware that the market isn't always very logical, and even overvalued stocks can continue to climb higher. Be sure to identify chart patterns, support and resistance levels to use them as potential price targets and, most importantly, stop-loss levels.
Step 2: Confirm that the stock is shortable.
Check to see if the stock is shortable at your brokerage. You can do this by placing a mock short-limit order a few dollars away from the bid price so you don't have a chance to get filled. If it's not shortable, it should immediately warn you that the order can't be put in. Some stocks are not shortable because the shares can't be borrowed due to limited liquidity or high volatility.
In instances where the stock is shortable, but there are no shares to borrow, you can contact your broker through your platform or via chat, email or phone and ask them to "locate" shares. Some stocks are hard to borrow (HTB) because the float may be small. Your broker may be able to locate shares to borrow for you to short, but it will cost you money. HTB stocks can be expensive to borrow and are very dangerous as they can be short-squeezed.
Step 3: Place your short-sale trade order on your brokerage platform or app.
Depending on your broker, you will have to click a tab or button that says, "Short sell to Open," "Short" or "Sell" to place the short sale order. You can place a limit price where you would like to short the stock or select a market order which will immediately fill your order on the bid price. Once you have selected the quantity and the short order, review it, click the confirm button and wait for confirmation. Once the trade is filled and executed, proceed to the next step.
Step 4: Monitor and manage the position.
Watch the price action closely and always be mindful of any changes to your thesis for the short position. If the stock starts to rise or fall, be aware of your price targets and stop loss levels. Since you are paying margin interest for holding short positions overnight, it's prudent to capitalize on sharp price moves down.
Step 5: Close out your position.
You will have to close out your short position eventually. Remember that you are paying margin interest and potential fees on the short position if it's an HTB security. That's why keeping most of your short trades intraday is prudent.
There is always an overnight risk, as good news or a strong gap up in the S&P 500 futures could gap the stock up against you.
You can close out the position by selecting "Buy to Close," "Buy to Cover," or "Buy." If the stock price is against you, close out your position to keep losses manageable. The last thing you want is to be caught up in a short squeeze that can result in heavy losses and a margin call.
Risks and Challenges
Short selling comes with many risks and challenges. Remember that short selling is much riskier than investing and playing long positions. The worst you can lose when you buy and hold a stock is 100%. However, a short position can move up when it rises and can continue moving against you, costing you much more than your initial investment.
Many hedge funds blew out during the GameStop Co. (NYSE: GME) short squeeze that ushered in the meme stock craze of 2021.
Short Squeeze
A short squeeze is a market phenomenon when a heavily shorted stock surges higher on heavy volume, causing short sellers to cover their positions to avoid larger losses. The catalyst for the short squeeze can be news or rumors that cause the bears to cover their shorts quickly.
As short sellers buy to cover their short position, it causes prices to rise rapidly as buying demand surges and feeds on itself. As the stock price moves higher, it can cause margin calls and forced liquidations, which add to the buying demand, pushing prices higher.
Check the short interest in a stock you are considering shorting. The short interest is the percentage of the stock's float that is already short. Stocks with a 20% or higher short interest tend to have the highest risk of a short squeeze. You may want to avoid these stocks until you become well-versed in shorting the market.
Short Sale Restriction (SSR)
Some stocks will receive a Short Sale Restricted (SSR) regulation implemented when their price falls by more than 10% from their previous close heading into the trading day. The United States Security and Exchange Commission (SEC) SSR rule protects companies from short sellers aggressively short selling and driving down the bids excessively. SSR should not prohibit short selling, just slow it down.
Margin Calls
Margin accounts are required to short stocks. They enable you to borrow the stock on loan. A maintenance margin threshold is established. The intraday trading margin is four-to-one leverage or 25% in liquid stocks. You only need 25% of the capital to establish a position because the brokerage can lend you 75%. Overnight margin positions usually have a 50% maintenance requirement due to the overnight risk.
If the stock you're shorting rises rapidly, you must cover the maintenance margin amount. You may get a margin call triggered if you don't have excess funds to meet the maintenance margin.
Margin calls trigger when the capital in your account isn't enough to meet the maintenance margin requirement. In these cases, you can transfer more money into your margin account or cover some or all of your short positions to meet the maintenance margin requirement. It's very important to know the maintenance margin for the stock you're shorting.
This is subjective to each brokerage it loans you the capital. They are on the hook for it initially, so they have the right to adjust the maintenance margin to control their risk. It's also possible for brokers to raise the maintenance margin on stocks for risk mitigation purposes. Brokers will often raise maintenance margins on specific stocks during the day that experience increased volatility. This can happen intraday without your knowledge and even trigger an automatic forced liquidation if the stock is short-squeezing too fast.
Forced Liquidation
A forced liquidation is exactly what it means. The stock you are short is surging so fast against you that the broker's platform will automatically cover your short position for losses to protect your capital. It can seem very unfair, but that is your risk when shorting stocks. That's why it's important to keep your stop losses without fail. It's important to keep tighter stop losses with HTB stocks and stocks with high short interest of about 20%.
Tips for Successful Short Selling
Short selling is one of the most riskiest trading strategies. Here are a few tips to keep in mind when starting.
- Avoid HTB and high short-interest stocks. HTB stocks are hard to borrow for a reason. They have smaller liquidity are tend to be volatile. This can be a recipe for disaster for short sellers as HTB stocks are very viable for a short squeeze.
- Falling markets tend to be more favorable for shorts. Stocks move with the benchmark indexes on a day-to-day basis. When the general market is falling, stocks are also more susceptible to falling. The context can make a big difference. Conversely, be hesitant to short stocks in a strong rising market.
- Identify overvalued stocks in sectors and industries. Do thorough fundamental research to assess whether a stock is overvalued relative to its sector and industry. Also, note if the sector or industry itself is overvalued. Make sure to have at least one bearish pattern in the stock to have targets and stop losses. Use multiple time frames focusing on the smaller time frames for a countertrend trade.
- Take your stop losses prudently. Administer the discipline to keep to your stop losses to prevent small losses from turning into large losses. Lack of discipline can result in blowing out your account with short selling. Always monitor your maintenance margin requirements and never overleverage your position.
- When in doubt, stop out of the position. If your original thesis for shorting the stock is no longer valid or has holes, then stop out. When in doubt, stop out to reassess.
Alternative Strategies
Now that you know how to short stock, you can also consider alternative strategies that still fall under the short stock definition. The biggest risk with short selling is losing more money than you have in your account. Blowing out your account is bad, but having to owe more money on top of that is like pouring acid into an open wound. There are other alternatives where your risk of margin calls and debt can be mitigated, especially when learning “How do you short a stock?”
Options Strategies
You can identify and limit your downside using options strategies. From buying put contracts to more sophisticated bearish strategies like administering a bear put debit spread for stocks you believe will fall. With these directional options strategies, you can only lose what you put into the trade, and the trade only costs a fraction of the capital needed to short the underlying stock.
Inverse ETFs
There are leveraged inverse exchange-traded funds (ETFs) for various sectors and industries and the benchmark indexes. These ETFs trade like stocks but inversely. For example, the ProShares UltraShort S&P 500 ETF (NYSEARCA: SDS) is designed to inversely mirror the single-day performance of the S&P 500 index and leverage ratio. If the S&P 500 index falls 2%, the SDS should rise 6% that day. Remember that inverse ETFs should not be held long-term since they naturally depreciate due to daily rebalancing.
An Expensive Learning Curve
This article covered the mechanics of short selling and the reasons you might want to short a stock. We covered the five steps to short a stock and the risks and challenges of doing so, especially short squeezes that can lead to devastating margin calls.
Don't expect to master of short selling right off the bat. Keep an eye on stocks with a high short interest. The learning curve can be expensive, so don't overleverage your positions and always be aware of the maintenance margin requirement levels for any stock you short.
Short selling is one of the riskiest strategies in a bull market, so always keep and adjust your stops as needed.
FAQs
Here are some of the frequently asked questions about short selling.
How does short selling a stock work?
Short selling is selling a borrowed stock and buying it back later. Preferably, the stock price falls when you buy it back, generating a profit. However, if the stock price rises, then you will incur losses.
What is the easiest way to short a stock?
The easiest way to short a stock is to use a market order. Assuming the stock is borrowable, this order will execute a fill at the current bid price.
How much money do I need to short sell?
Short selling requires a margin account. To avoid the Pattern Day Trader (PDT) rule, you must have at least $25,000 in a margin account to trade. However, having at least $30,000 is better, so you aren't limited. If your account capital falls under $25,000, the PDT rule limits your trades to only three round trips during a rolling five-day period. While you may choose to short a stock with less than $25,000, the PDT may result in you having to sit through losses to avoid triggering a penalty if you already made three round-trip trades.
