What does shorting a stock mean? Shorting stocks is the opposite of going long. This strategy allows you to make money as a stock falls. Look to sell a stock near resistance levels, which creates a negative position. Then you buy to cover at support levels, your position is closed, and you keep the difference. Example: If you sell at $2 and cover at $1.80, you make $0.20 on the trade. You need specific brokers that allow you shares to borrow to short and not all brokers have good short locates.
Table of Contents
- What Does Shorting a Stock Mean?
- How Does Shorting Work?
- Shorting a Stock Example
- What Is Short Covering?
- Pros of Short Selling
- Cons of Short Selling
- Frequently Asked Questions
What Does Shorting a Stock Mean?
Shorting a stock means that you are taking a bearish position on a stock. The way that you do this is by borrowing shares from your broker, which is an automated process. This creates a negative position in your account. So, you sell high by borrowing shares then you buy low to cover your position and then you’ll be back to even in your account.
Shorting is something you want to learn and understand fairly early when you start out on your quest to learn trading. When you short sell a stock, you’re borrowing shares from your broker and selling them on the open market with the expectation the stock will go DOWN IN VALUE. Then you “cover” or buy back the shares and keep the price difference in profit!
Short selling is a very popular trading technique for experienced traders. Short sellers especially enjoy shorting junk stocks that have ran too far, too fast and are ready to crash back to reality. Penny stock are our favorite to short, because so many of them have weak fundamentals. But occasionally the blue chips and large caps are great shorts too.
What does short selling mean? This is a question every trader should be able to answer. Especially when trading penny stocks. It’s important to be able to make money in any market whether bullish or bearish. If you’re planning on being an active trader, short selling is a tool you’ll want in your bag. If you’re just a bull, you can sit around to wait for the trend to change, but where is the fun in that? If you’re trying to trade full time, you’re going to be sitting on your hands a lot waiting for bullish setups. Sometimes you just can’t find them or they just aren’t there. Hence the need for shorting!
Learning how to short gives you the skill to make money in a down trending stock or market. The market trades in cycles and prices go up and down like (like a roller coaster sometimes).
If you don’t have the skill to make money in a bear market, you’re leaving profit for someone who does know how to take advantage of the shorting opportunity.
Learn how to short stocks by taking the time to study and practice. The ability to trade any market is a skill every trader needs if they want to survive long term.
How Does Shorting Work?
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.
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.
Why Short Sell?
So why short sell? You believe the stock you’re looking at is going to go down in price. You’re bearish on the stock! With this in mind, you go to your broker and ask to borrow shares at the current price. You just select the number of shares you want to sell, and click sell. Do a limit order, typically, not a market order. When you sell the shares SHORT – you see a – negative balance of shares in your ledger. You’re making money as long as the stock moves LOWER than your entry price.
You then buy the shares back at the lower price, return those shares to your broker (automatically) and pocket the difference. In other words, you’re selling shares you technically don’t own “short” then buying them back at a cheaper price (hopefully). Here’s an example of a short setup on $APPS. See the entries you would short and cover? This would be considered scalping as day trades.
Some days the buyers win and other days the sellers win. You also have some mornings where the bears win, but afternoons where the bulls take over. It can change so quickly…you need to have a system in place to recognize the signals of when you should go short and when you should go long. If you don’t want to short, you can always sit out the days the sellers (bears) are in control.
Shorting a Stock Example
Here’s an example of shorting a stock:
- $AAPL (Apple) is at $300 resistance level
- You take short position on Apple of $100 shares. 100 x $300 = – $30,000)
- Apple falls to $290 and then you cover your position
- Your Profit = $1,000 ($300-$290 = $10. $10 x 100 shares = $1,000)
Shorting rising wedges is great when a stock is over extended.
Alright what do I mean by knowing who you are up against? Well, if you’re a bull on a stock, there are bears out there. Bears who are short. They’re short selling while you might be buying. That could be a problem for you if you’re a bull. Think about the struggle that you’re participating in. What is your enemy thinking at a certain support level or resistance level? Get in their heads, and you’ll become a better trader.
In the grand scheme of things, no one way of making money in the market is better than the other. However, having the skills to trade multiple ways can give you more opportunities. There are some days the Japanese candlesticks patterns are ripping and other days it’s slow and boring. You take what the market gives, and you use whatever strategy works, or you sit it out until your setup shows up.
Then there are days the market is a bloodbath of red, you can still make a profit. If you have educated yourself.
Your Broker Is Important
Not every broker has the capability to short sell certain stocks. Hence the need for a good shorting broker; especially if this is your primary way of trading. You also need to be approved to short sell by your broker. This usually means answering a few questions before they approve you.
There are some brokers that will have shares to short of certain stocks but certain stocks that are less popular or have lower floats…you might find it difficult finding shares to borrow.. If you’re OK not having every stock available to you to short then your broker options are more diverse.
Do your research and find the shorting broker that works best for your needs. CMEG is also good, and they have no PDT rule.
However, if you don’t want to get a new broker you can trade put options. Put options are a form of short selling.
There are a couple schools of thought when it comes to risk and whats involved with short selling. The ones who think it’s way too risky and don’t ever do it. The others are traders who prefer to trade by shorting only.
Sure short selling is risky but isn’t trading in general? What should happen on every trade, long or short, is applying risk management. When you apply proper risk management, you’re going to keep your losses small when a trade goes against you. Including shorting a stock.
In theory, short selling has unlimited risk potential. When you long a stock, you can only lose what you invested. A stock isn’t going to have a value below zero.
However, when shorting, you’re betting a stock is going to go down in price. Instead, it can reverse and go up; and go up forever. Hence the potential to lose more than you even have in your brokerage account. Be aware of this! Have an entry, and exit and a stop level on every single trade.
Implement a stop loss whether with your broker or mentally. If you’re not willing to lose more than lets say ten cents, set a 10 cent stop loss. Beware of low float stocks and the tendency to trigger stops before heading back down.
The risk management you employ should be what you’re comfortable with and one that you’ve practice. That way you know it’s a winning strategy.
Companies Short-Sellers Target
- Small-cap companies that are pumped up by momentum traders, especially companies that are difficult to value.
- Look for companies with P/E ratios much higher than their growth rates can justified.
- Companies with weak financials like a bad balance sheet or negative cash flow, etc.
- Companies that rely too heavily on one product
What Is Short Covering?
The process of short covering is when a trader buys back securities that they’ve borrowed for a currently open short position in order to close it. This purchase will result in either a profit when the asset is repurchased for a lower price than it was sold. Or a loss, if the asset’s price is now higher. Short covering requires that the same security that was sold short be purchased.
And the borrowed shares get returned to the broker. Short covering can also be called a buy to cover or buying to cover.
Let’s dig a little deeper. A short cover begins with an investor that sells a stock. Or another asset, we’ll use stocks from now on. In fact, they don’t own in a short position.
They borrow this stock from their broker to sell it to someone else. This short position is a bet that the price of the stock will decline.
A short position is exited by buying back the borrowed shares that were sold so that they can be immediately returned to the broker from which the original shares were borrowed.
When the shares are returned, the position is closed, and the transaction is finished with no further obligations of the trader to their broker.
Why Do Shorts Cover?
There are several reasons that a trader will choose to cover their short positions. If there is a drop in the stock’s price, as the “seller” had predicted, the seller can then purchase the shares in the company from any current seller for less than what is owed to the brokerage for the borrowed shares. This situation would be a profitable one for the trader when they cover the short.
When a trader shorts a stock, there is potential for unlimited loss because their downside is equal to the theoretical price of the stock, which is limitless because the stock’s price could go to infinity. Therefore a rising stock price will also cause traders to cover a short position to limit their losses. Why do shorts cover? Now you know.
Short Covering Example
Say you are an immunologist and also an investor and find out about a new virus from China. You think this will cause ABC’s stock price, which is sitting at $100, to go down. You sell ABC short, borrowing 100 shares from your broker. And resell at $100, putting $10,000 in your pocket. But you owe your broker the 100 shares.
ABC’s stock does decline when the virus hits the U.S. and drops 30% to $70. And you cover your short by buying 100 shares for $7000. You give those shares to your broker. And now you have a profit of $3000 (less your fees).
The Short Interest Ratio
The more short selling there is, the higher the Short Interest Ratio (SIR), and the risk of short covering increases.
Short covering will often start a bull rally after a long bear market.
A short seller’s investment horizon is much shorter than a long holder’s because of their unlimited downside risk.
And it will cover their positions to prevent significant losses if investor sentiment changes.
If you’re going to short, make sure you know that the stock is going to move down. If the trade goes against you, then you could lose a lot of money.
And that’s something no trader ever wants to do.
The Short Squeeze (From Too Much Short Covering)
Short squeezes happen when many traders have a negative company outlook and sell short without borrowing the shares, AKA a “naked short”, pushing the number of shares shorted above the company’s actual share count.
Then something causes company sentiment to change, and many investors must cover their short sales, but there are no shares to buy, resulting in a “squeeze.” The price then spikes higher, and brokerages will issue a margin call to have shares returned, further increasing the need to buy shares to cover positions, and the price spikes even more.
GameStop Short Squeeze
The video game retailer GameStop was in the news for its short squeeze. The company was losing sales to digital downloads. Seventy million shares of Gamestop had been sold short in Q1 2021; however, only 50 million GameStop shares total were outstanding.
GameStop’s earnings beating expectations, combined with retail online forum members buying and holding, caused the stock price to rise. “Smart money” which had purchased significant short positions, had to cover them, and GameStop’s price increased 1700% in a month.
The Gamestop short squeeze exemplifies the risk possible with short covering. Massive losses are possible, so keep an eye on the SIR if you are shorting. Identifying a short squeeze is not easy, but when possible and early enough can be quite profitable.
In a bear market, selling short can undoubtedly be profitable but look for the short covers that indicate a turn towards the bulls. Building portfolios with a small proportion of assets selling short and for finding short squeezes while dedicating more to going long in companies with promising futures is probably the best strategy.
Pros of Short Selling
- Traders can hedge their bets. For those traders who are worried about losing money, they can open up a short position. Likewise, this helps them to keep the stock price that is already there at the time. You then don’t have to worry as much about dropping prices because you get an increase if that happens.
- Traders can capitalize on overpriced/overvalued companies. We have a few different scenarios you can capitalize on. First, you think that a stock price is worth more than you think. Secondly, you may think somethings going to happen to decrease the value of the stock. With both of these scenarios, you can use a short position.
Cons of Short Selling
- Unlimited Loss Potential. For starters, someone who has bought actual stock can only lose 100% of their capital if the stock tanks to $0.00. However, someone who has shorted stock can lose more than 100% of their original investment if the price skyrockets. The risk to you is if you don’t have a stop in place. Because there is no ceiling for a stock’s price; it can rise to infinity and beyond.
- Margin Trading. Shorting is also referred to as margin trading. Essentially you borrow money from the brokerage firm using your investment as collateral. Akin to going long on margin, it’s easy for losses to get out of control. You must also meet the minimum maintenance requirement of 25%. And unfortunately, if your account drops below this, you’ll be subject to a margin call and forced to cough up the cash or liquidate your position.
- The Dreaded Short Squeeze. A stock that’s actively shorted with a high short float and days to cover ratio is ripe for experiencing a short squeeze. A short squeeze happens when a stock begins to rise in price for whatever reason. Predictably, short-sellers cover their trades by repurchasing their short positions, which triggers a feedback loop. The increasing demand attracts more buyers, which pushes the stock higher. In turn, this causes even more short-sellers to buy back or cover their positions.
Lets recap what it means to short a stock. First It means you believe a stock is going to go down in price. Second, you borrow shares from your broker and third, after any amount of time, you buy back the shares at a lower price (hopefully you got a good entry on the short and made money).
It has its risks, like any type of trading. Hence the need to open a paper stock trading account and practice. Make many practice trades before going live, work out the kinks. Start out with small positions and then scale up.
Frequently Asked Questions
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.
What Happens If You Short a Stock and 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.
What Is Short Selling?
Is Short Selling Ethical?
How Much Can You Make Short Selling?
To calculate your profit, you simply take the difference between the price at which you sold the stock and your cost to repurchase it. Oh, and don't forget the cost of commissions and expenses for borrowing the stock in the first place.
But what if your analysis is wrong and the price of the shares increases? In this scenario, your potential losses are unlimited. At some point, you have to replace the 100 shares you sold or "borrowed." In that case, your losses can mount without limit until you cover your short position.