Your Ultimate Guide To Short Selling Stocks: Do-s And Don’t-s

Your Ultimate Guide To Short Selling Stocks: Do-s And Don’t-s

Most people invest in the stock market with the hopes of their investment gaining in value and selling it at a higher price - netting a profit. 

However, this is far from the only method of making money on the stock market. Leverage has long been an integral component of trading and many market participants choose to invest when others show signs of greed and the market is profoundly overvalued. This is done by short-selling, which is the process of borrowing shares from a stock broker in the hopes that the shares will fall in price over a set period of time - buying back and returning the borrowed shares to the broker at a lower price - pocketing the difference as profit. 

There are limits as to how much traders can borrow, as short-selling can be a highly risky strategy that requires a solid knowledge of the market, as well as a higher risk tolerance. 

Despite this, short-selling can be a very rewarding strategy when done effectively. 

You can read more about the opportunities and common pitfalls of short-selling stocks in this guide from the investfox analytics team. 

What Is Short Selling And How Does It Work?

Short-selling is a stock trading strategy that allows investors to profit from the decline in the price of a stock. 

It involves borrowing shares of a stock from a broker and selling them on the open market, with the intention of buying them back at a lower price in the future to return them to the broker.

The process of short-selling can be broken down into several steps:

  • Borrowing shares - the first step in short-selling is to borrow shares of a stock from a broker. This is typically done by the investor via their brokerage account. The broker lends the shares to the investor for a fee, and the investor is required to put up collateral to cover any potential losses
  • Selling the shares - once the investor has borrowed the shares, they immediately sell them on the open market at the current market price. This results in cash being credited to the investor's account
  • Waiting for the price to drop - the goal of short-selling is to profit from the decline of a stock’s price. The investor waits for the price to fall so they can buy back the shares at a lower price 
  • Buying back the shares (covering) - when the stock's price has dropped to the desired level, the investor buys back the same number of shares they originally borrowed and sold. This is referred to as "covering" the short position
  • Returning the borrowed shares - the investor returns the shares they borrowed to their broker. The broker removes the borrowed shares from the investor's account, and the short-selling process is complete
  • Calculating profit/loss - the investor's profit or loss is calculated based on the difference between the selling price of the borrowed shares and the buying price when covering the short position. If the stock price has fallen, the investor makes a profit; if it has risen, they incur a loss
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Depending on the stock of your choice, the broker may or may not limit the amount you can borrow. This also depends on the amount of capital you have available on your balance, as well as the level of experience you have with leveraged trading. 

In general, brokers classify two types of shares for short-selling - HTB and ETB. 

ETB stands for “Easy To Borrow”, which means that the stock is highly liquid and the broker has a decent number of holdings to let you borrow for your short position. An example of ETB stocks are those that are part of the S&P 500 or Nasdaq-100 indices. 

HTB stands for “Hard To Borrow” and may include highly illiquid stocks that are traded over-the-counter or simply have a very low market capitalization. 

Most brokerages that operate on a Direct Market Access framework will allow brokers to submit a request for the stocks they would like to borrow for their short positions. 

Short Selling Stocks - Things To Consider

Short-selling has no upper limit as to how much a trader can lose on their position. As stocks do not have a theoretical price ceiling, an unsuccessful short position can quickly turn into a nightmare scenario if the risks are not properly managed. 

Here are some key considerations before opening a short position:

  • Timing - choosing the right time to enter a short position is important, as you wouldn’t want to be caught in a trend reversal as you’re opening a short position 
  • Exit strategy - have a well-defined exit strategy. Determine your profit-taking points and stick to them. Avoid becoming too greedy and holding onto a short position for too long
  • Short squeeze - check the overall short interest of the stock of your choice, as well as the progression of short interest over time to avoid getting caught up in a short squeeze, which can lead to massive losses in a very short period of time 
  • Stop-losses - always implement strict risk management strategies. Set stop-loss orders to limit potential losses if the stock's price moves against your position. Determine how much of your portfolio you're willing to risk on a single short position
  • Thorough research - this goes without saying, but it is crucial to conduct thorough research before choosing the stock to sell short. Try to find as many relevant justifications for the decline of a stock as possible, by using a variety of valuation metrics for the underlying company, such as Discounted Cash Flows (DCF), price-to-book value, etc.

Short Selling Stocks - Pitfalls To Avoid

When short-selling stocks, there are a few major pitfalls you need to avoid to ensure that your trades don’t lead to disastrous losses. 

It is all too common for short-sellers to become greedy and start chasing a downtrend even after a few failed attempts. When the market is not going your way, it is better to close the position and cut your losses, as negative emotions can cloud judgment and cause more losses than would have otherwise been manageable. 

Overusing leverage is also a bad idea when it comes to short-selling, as stocks are borrowed and if the trade goes against you, you will be forced to buy them back at a higher price. If you cannot afford to do that, the broker will liquidate your assets and lock your account until you pay back what you have borrowed, which can lead to unnecessary complications and potential legal disputes. 

Placing a stop-loss at a reasonable level is crucial to limit the potential downside of your short position. As stocks do not have an upper price ceiling, an unsecured short position can theoretically continue burning cash indefinitely. 

Margin calls

A margin call in short selling is a situation where a broker demands that a trader who has engaged in short selling deposit additional funds or securities into their margin account. 

This requirement is triggered when the value of the shorted stock rises significantly, causing the trader’s potential losses to exceed the initial margin requirement. 

The initial margin is the amount of money a trader needs to have in their trading account to cover potential losses. When these potential losses approach or exceed the initial margin, the broker may issue a margin call. 

The margin call requires the trader to deposit additional funds or securities to the margin account to bring it back in line with the maintenance margin requirement. 

Failure to meet a margin call can lead to the broker taking action to cover the position, which may involve buying back the shorted shares at the current market price. This can result in the trader incurring substantial losses if the stock price has risen significantly since the initial short sale. 

Key Takeaways From Your Ultimate Guide To Short Selling Stocks

  • Short-selling is a trading strategy that involves borrowing stocks from a broker and returning them at a lower price for a profit 
  • Short-selling can be highly risky, as there are no theoretical limits for how high a stock’s price can go, forcing the trader to buy them back at an increasingly higher price
  • If the trader’s potential losses exceed the margin requirement set by the broker, they will be required to add more funds/securities to the account to pay back the broker 
  • Short-selling is a strategy that is not advisable for beginners, as it can lead to substantial losses far exceeding the margin requirement

FAQs On Short Selling Stocks

Is short-selling risky?

Short-selling is considered a high-risk strategy that requires a good understanding of the market and has no theoretical loss limit, which makes it less advisable for beginner traders. 

What is a margin call in short-selling?

A margin call happens when the broker demands that the trader who has been short-selling deposit additional funds or shares to their margin account to bring the value back to the initial margin requirement. 

Should you use a stop-loss order when short-selling?

Yes. stop-losses are a great way to limit the potential loss you can incur on a given short position by buying the stock back at a price lower than the selling price.