How does shorting work? Watch our video to learn more.
How Does Shorting Work?
- Here's how shorting works:
- Sell high at resistance levels
- Borrow shares from your broker
- Start off with negative position
- As price falls "buy to cover" your position
- Position then goes back to even
- Keep the difference in profits
- Need a good shorting broker like Interactive Brokers or SpeedTrader
- Be aware of PDT limitations
- Be careful holding overnight or long term
A question asked by many new traders is how does shorting work. Everyone wants to be able to make money in any kind of market; whether bullish or bearish. Shorting allows traders to capitalize on bear markets when the charts are red.
The stock market is a tug of war between buyers and sellers. Most traders know how to trade bullish candlesticks when buyers are in control. What happens when charts begin to turn red and bearish candlesticks reign supreme?
It's smart that traders learn how to profit in any market. A strong market isn't going to last forever. When the tides turn, can you profit as well?
Emotions move markets. This is how we got candlesticks patterns. Greed and fear are profitable.
How does shorting work? When a stock is falling in price the strategy implemented to profit is called short selling. Shorting is actually pretty simple.
You borrow a stock from your broker. Then sell it. Next you buy back the shares to return to the broker you borrowed from. When you cover your short position you're not keeping the stock (check out a list of brokers with no pdt rule).
In other words, you're betting that a stock will fall so you go to your broker to borrow the shares at the higher price. If price does fall, you then buy it back at the lower price and return it.
You profit from this strategy by keeping the difference of the price you borrowed at to the price it fell to. For example, you believe NVDA is overvalued at $260. You borrow the stocks at that price.
It does indeed fall to $252. You then cover at that price. You would have made $8 a share.
2. Basics: How Does Shorting Work?
Shorting stocks can sometimes be looked down upon by long term investors. They view shorting as a way to screw them out of profits but that's not the case. How does shorting work?
Shorting is actually great for keeping the markets liquid. Imagine if no one shorted. Price would continue moving up until no one would be able to afford to buy stocks. You'd have to have huge accounts or be apart of a large company that traded for a living.
The average traders like us wouldn't be in the game. Shorting keeps that from happening. When a stock gets too overextended, it moves back down. This, in turn, allows traders with any account size to play the markets.
Thanks to shorting you can learn how to invest in the stock market with little money and grow your account into something big.
Why Short Selling Is Bad?
- Short selling is a very profitable trading strategy, however, there are times when it can be bad. Theoretically, you can lose an infinite amount of money because there is no ceiling on how high a stock can go. Also, there can be broker limitations on locating shares to short. Like any strategy though, it's important to understand proper risk management.
Short selling is risky business. When you long a stock, you're only using the money you invested. For example, if you bought SQ at $50, you can only lose $50 because a stock can't go less than $0.
Shorting is a bit of a different animal. How does shorting work? Theoretically you can lose an infinite amount. Stocks can keep rising in price forever. Let's use the same example from above. You bought SQ at $50 thinking it was going to go down in price. Instead it went up. You finally covered at $60.
That's a $10 loss per every share you owned. If you didn't cover then, you could continue losing money, wiping your account out.
This is why trading risk management is so important, especially with shorting. If you're only willing to risk $2, then you would lose a lot less. Set a stop with a close above where you opened the short position.
Risk management allows you to lose less than you could. No trader wins 100% of the time. Keep your risk management tight and you'll keep your losses small (book mark our stocks lists page which is updated daily).
Patterns are incredibly important as you ask how does shorting work. Going long on a bearish pattern such as head and shoulder patterns is going to cause profit loss. The opposite is also true.
Going short on a bull flag pattern is a recipe for disaster. You need to know patterns. What do they look like and what do they mean? What do you do when you see shooting star patterns?
Learn patterns and candlesticks and you'll know when to go long and when to short. Patterns do break down all the time so get confirmation and look at technical indicators.
Candlesticks tell a story. So do patterns. Technical indicators can confirm those moves. Everything works together.
We share our stock scanners live each day within our trading service.
What Happens If You Short a Stock and It Goes Up?
- Here's what happens if you short a stock and then it goes up. You will lose the difference between your short price and the current stock price. If you shorted at $10 and the stock price went up to $11 then you lost $1 per share times the number of shares.
1. How Does Shorting Work With Support and Resistance
How does shorting work also relies on support and resistance. Support and resistance are key levels that traders pay close attention to. When shorting, you want to buy at resistance and sell at support.
The real bodies and wicks of candlesticks provide support and resistance. You can see that in triple top patterns. Price tried to break resistance three different times and couldn't. The shorts came in and pushed price down.
Moving average lines and VWAP also provide these key levels. You'll notice how traders and price react to the indicators and support and resistance.
Practice and pay attention.