How Does Shorting a Stock Work

  • August 14, 2019

Watch our video on how does shorting a stock work.

How Does Shorting a Stock Work? (Short Selling Breakdown)

  1. How does short selling work in practice? Simple basics on shorting a stock:
  2. Sell high near resistance levels
  3. Buy low to cover
  4. Keep the difference in price
  5. Borrow shares from your broker
  6. Negative position to start then evens out when you cover
  7. Need a good shorting broker
  8. SpeedTrader, Centerpoint, Interactive Brokers, LightSpeed
  9. Very popular day trading strategy
  10. Be careful holding overnight

If you're wondering how does shorting a stock work, you're not alone. You've probably heard it's risky or dangerous but what's dangerous is not taking the time to educate yourself. Watch our video on how to short a stock. 

You need to be able to wrap your head around the concept of “shorting” the market. Because you know what, you can make money in a decreasing market. 

1. Going Long

Can answer the question how does shorting a stock work? Most investors “go long” on an investment, hoping that price will rise. You’ll hear them say “I am long 100 shares of Facebook (FB)” for example. 

Okay, that's great but what do you do if prices are dropping? Well to profit from the stock price going down, you borrow shares from your broker and sell them.

You then hope the price goes even lower so you can buy them back at the lower price, return the shares to your broker and keep the profit for yourself. What I just explained to you is known as short selling or simply short. 

When people say they're “short 100 shares of FB”, it means they have sold short 100 shares of Facebook and they hope the price will drop even further. You’ve done your due diligence; fundamental and/or technical analysis depending on the type of trader you are.

2. Borrowing: How Does Shorting a Stock Work

In essence, you “borrowed” the 100 shares and you owe them back to your broker. Now your broker doesn’t want your money, they simply want their shares back (check out a list of companies with no pdt rule).

Before you return the shares you hope the price will drop even further so you can buy them cheaper than what you sold them earlier and make a profit.

This debt is reflected in your account with a negative sign in front of the ticker, in this case -100 FB. 

How Does Shorting a Stock Work

How Does Short Selling Work in Practice (Example)

  1. Here's how short selling works in practice. Example:
  2. Let’s say 100 shares of FB you borrowed cost $100 per share
  3. Bad earnings hits and the share price drops to $90
  4. This isn’t bad news for you as you as a short seller
  5. Simply buy back those 100 shares at $90 and return them to your broker
  6. This is done automatically
  7. When you do the math, you'll see you’ve made $10 per share or $1,000. 

Our service believes in being able to answer the how does shorting a stock work question. As a result, our day trading course teaches you about shorting.

1. Why I Like Going Short More Than Going Long

To be honest, I love short selling because people and patterns are predictable. Think of it like this, good news comes out, people rush in to buy, excitement is everywhere, more people jump in, greed is abundant everywhere. Keep an eye on volume.

If you’re patient, you know that eventually, this will wear off and all it takes to change attitudes is a sniff of uncertainty or fear. Hence knowing the answer to how does shorting a stock work.

Quite frankly, fear is a more powerful emotion than greed. And you see this reflected in the fact that stock prices generally drop much more quickly than they go up.

As a short seller, if you can catch this panic and sell off at the right time, you can make astonishing profits. We catch these moves in our trading rooms quite often.

How Do You Borrow a Stock to Short Sell?

  1. Simple steps on how to borrow a stock to short sell:
  2. Choose a broker that has good short locates
  3. Borrow the stock to short sell
  4. Simple process done through broker system
  5. Put in a limit order to sell: to enter initial position
  6. Or use hot keys, sell ask, sell bid: enter initial position
  7. Negative position at first
  8. Cover position buy putting a limit order to buy at specific price: exit position
  9. Or use hot keys to buy ask, buy bid: exit position
  10. Position back to neutral again and keep the difference

1. The Downside of Shorting

As with going long on a stock, going short on a stock has its risks as well. You could very well short a company at $30 a share thinking it’s going to continue to tank.

Instead of going down, the price starts to rise further and further. In reality, the stock price could go to $100 and there would be no limit to your loss.

What’s more, your broker still wants their shares back. So not only can you lose all of the money in your account but if you don’t have sufficient funds to cover your short position, your broker could sue you. 

It’s for these reasons listed above, the importance of risk management and having stop-losses in place can’t be stressed enough. This goes both ways whether you’re going long or going short.

In order to prevent losing your hard earned capital, you just have a stop-loss in place that risks no more than 2% of your account size. Simple as that. We’ve covered risk management extensively on our stock market blog so please take the time to read it.

You can't answer how does shorting a stock work if you don't understand risk management. In fact, we have a penny stocks list that has both long and short plays on it.

Think of it like this, if there’s no one to balance out the market, the price of stocks could increase higher and higher. We need short sellers to ensure the market is balanced, and companies aren’t overvalued. 

How does shorting a stock work? In essence, it helps to keep the market balanced. Stock training teaches you to short a stock and keep the market in check.

What Happens If You Short a Stock and It Goes to Zero?

  • If you short a stock and it goes to zero then a couple things happen. If you catch it before it goes to zero and you're able to cover your position then you will profit. However, heading to zero would be bad and means company is probably bankrupted or delisted, which means that you wouldn't owe anyone.

1. Wouldn't Brokers Short Sell Themselves Instead of Letting Me Borrow Shares?

Great question and one I pondered many times when first starting out. The answer is that many investors who hold long positions in stocks would rather hold them over the long term.

Short selling allows these investors to make extra money by “lending” the shares to short sellers.  Another key point to realize is that they have invested in a company for the long haul.

They have no interest in quickly making a profit from the short-term fluctuation in the share price. Therefore, they willingly lend their shares to short-sellers.

The extra money comes in the form of interest charged on the shares lent. So not only do you have to pay the actual share price to your broker, you need to pay interest as well.

Understanding that helps you understand how does shorting a stock work. Check out our real time stock alerts if you want more ways to trade.

2. How Does Shorting a Stock Work and Is It Dangerous?

Yes and no. I would say anything is dangerous if you don’t have proper risk management strategies.

That can be said as well if you don’t have tried and tested strategies down pat as to when you will enter and exit a trade. The set up needs to be there with the proper indicators, otherwise, you’re gambling.

Another key point to how does shorting a stock work; don't assume you'll always be able to buy it back whenever you want, at the price you want.

To put it another way, the market "buyers" need to be there and want to buy it. Or you'll experience panic buyers caused by other short sellers trying to close out their positions as they lose more and more money (read about the different types of stocks).

3. Is It Dangerous...Continued

The price ends up spiking and your're caught in the short squeeze. As a result you might be in a position to incur some serious losses.

You might be faced with the dreaded "news" situation. How many times have you woken up to the news of a company getting acquired. This happens all the time.

What if you're short in the company and it's getting acquired for a 40% premium over and above the current stock price. What's more, they're throwing in a special $10/share dividend, for example. End result, instant negative impact to short sellers.

You could also wake up to an announcement that a company's getting acquired for a 40 percent premium over its current stock price including a special $10 per share dividend, for example, which means short sellers are instantly impacted and may have serious losses. Try our day trading room free for 14 days. 

How Much Money Do You Need to Short a Stock?

  • The minimum requirement on how much money you need to short a stock is $2,000 because it requires a margin account. Once you have this capital in your account then it requires the price of the stock times the number of shares.

1. How Does Shorting a Stock Work With My 3 Favorite Patterns

How does shorting a stock work? Some strategies only work for short selling and as you can see below, I’ve included a few of mine that I really like. In fact, if you head on over to the Bullish Bears website we have lots of free material to get you started. 

2. Shorting Stocks That Go Parabolic

How Does Shorting a Stock Work

What Are Stocks That Go Parabolic? Stocks that go parabolic are those that gap up significantly on the same day.

What I Like To Do? Short into the overhead resistance.

Why Does This Strategy Work? 9 times out of 10, after a huge gain, a stock will wash. Just look at this example from CARV. It opened at $4 and ran up to $12, a 66% gain.

So, I anticipated that the next day it wouldn’t be able to hold the gains. I simply plotted the previous day close and any overhead resistance lines and waited. And sure enough, it washed.

Or in essence, how doe shorting a stock work in action. Take our basic trading course.

How Does Shorting a Stock Work

3. Day After 1st Red Day Strategy

How Does Shorting a Stock Work

What Is The Day After The 1st Red Day Strategy? Typically, what I’ve noticed that with stocks that have a massive run-up, the day after the first red day, they perform weakly. I wait for the first red day, where the stock closes lower than it opened.

Why Does This Strategy Work? Because as you know, everything that goes up, must come down. And anything that has had a massive run up and a wash finds it difficult to recover to previous strength levels.

What I Like To Do? What I look for are stocks that have had a big run up over the course of a few days or even weeks. As you can see in the LGCY* chart below, it ran for about 9 days, going from $6-$10. I plot the previous day's close price - teal resistance line, additional resistance levels - red lines and I wait for the morning run up/spike to short into the overhead resistance. How does shorting a stock work?

Shorting a Stock

*Disclaimer for this chart. I probably wouldn’t have traded this as the volume was really low. I just wanted you to see the Day After First Red Day set up.

4. Shorting Late Day Fades

Shorting a Stock

What Is The Shorting A Late Day Fade Strategy? Instead of a stock that goes parabolic out of the gate at 9:30 am, some stocks slowly grind up during the day. See LCI below. Alternatively, some stocks run parabolic, pull back and consolidate, have another push late in the day then a wash. This can be seen in the first image above.

Why Does This Strategy Work? Typically a stock that has been grinding up all day will eventually run out of gas and wash. Most often than not, this wash starts to happen somewhere between 2pm and 4pm.

What I Like To Do? I use this strategy on days that I can’t get to my computer until the afternoon. I’ll do a quick scan of stocks up over 20% - FINVIZ is sufficient for this, you don’t need fancy scanners. I then plot my overhead resistance lines and wait for the signals to enter. As you can see below, LCI had a 40% slow grind up all day then finally washed late afternoon. How does shorting a stock work.

Shorting a Stock

Final Thoughts: How Does Shorting a Stock Work

All things considered, short selling is not that risky if you take the time to build your foundation of knowledge. So do your homework, practice doing these trades on paper, and see how you do.

Trust me, it gets easier as time goes by and luckily we have a great team to help you succeed. Click here for our 14 day free trial and watch and see why you are our passion!

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