When it
comes to trading, there are many ways you can earn money. That’s true for stock
trading. In trading stocks, you can earn even if the value of your company
depreciates. One of the ways you can use is short selling. Let’s dig deeper
into how this one works, and how you can use it to your advantage.
Read further: Beginner's Guide to Stock Trading
Going
short
“Selling short,”
“short selling,” or “going short” is a technique that people use to try to earn
something out of the falling price of a stock or a currency. Short selling is
quite risky. This is because it requires you to have precise timing. It also
goes counter to the overall direction of the market. Historically, the stock
market tends to rise in value as time goes by. And because of this, you have to
be keen in your predictions, which is something difficult for traders.
How it
Works
Let’s try
to illustrate how short selling works.
For instance,
suppose you want to short sell 100 shares of a company. You believe that the
company’s sales are showing weakness. Consequently, its earnings will drop. Now,
your broker will borrow the shares from another entity that owns them. The
broker will promise to return the borrowed shares later.
What you
will do is sell the borrowed shares at the current market price at once. Of course,
you’re hoping that the price of the shares drops. You “cover your short
position” by buying back the shares.
Your broker
will come in the picture again, because he will have to give back the borrowed
shares to the lender.
Where do
get your profit?
You get it
from the difference between the price where you sold the stock and the cost at
which you bought it back. Keep in mind that you still have to subtract commissions
and expenses for borrowing the stock.
What happens
when the price does not go the way you wanted it to?
If the
shares’ price increases, the possible losses that you will incur will be
unlimited. It’s possible for the company’s shares to soar up and up and up, but there will be a time when you have to replace the 100 shares you sold. In that
case, your losses will skyrocket until you finally manage to cover you short
position.
Learn more about preventing risks, read Breaking Down Risk Management
Why Short
Selling is Good for Some Traders
There are
many reasons why short selling is a good idea for some traders even though
there’s the risk of losing a lot of money.
First, some
types of investors aren’t that keen on searching underpriced but good
companies. Instead, they’re better suited at identifying overpriced but bad
companies.
Generally, your broker and many analysts concentrate at finding which
to buy, not which to sell. That means that they won’t focus on bad news. They’re
keeping more tabs on the good news. When the analyst recommends you to sell a
stock, it doesn’t mean that he had some easy time getting information from
the company’s investor relations department. The analyst’s firm cannot possibly
get an opportunity to raise capital or float a bond.
See also: Qualities of a Good Broker
Second, a
huge number of institutions do not do short selling. That means there are tons
of short selling opportunities for you to grab.
Lastly, if
your portfolio includes both long and short positions in the stocks that
usually move together, the portfolio will tend to sport lower volatility.
Learn more about portfolio management, read Portfolio Management: Learning the Basics
Caveat
As indicated
above, short selling also entails risks.
First, most
short sellers want to limit how much they lose, of course. However, you can be
a victim to a short “squeeze” where investors (who are going long) buy shares as the stock
rises and demand delivery. As you try to
cover your losses, the price climbs up and up. It would then push more short sellers
to cover their losses.
This risk
typically applies to smaller and less liquid companies. Then, even if the
stock is considered overpriced, it may still become more overpriced. Of course,
you will definitely have to buy the stock at some point.
Second, you’re
trying to battle against the trend of the market, which is up in the longer
run. When you go long on a stock that you believe is undervalued, you will be
content to wait for it just to earn something out of it. However, if
you’re going short, as mentioned, you will have to buy the stocks at whatever the
price the market gives it at one point.
Lastly, it
is possible that another company will acquire the company you’re shorting. It’s
also equally possible that the acquisition will be at a significant premium. That
premium will push the prices even farther upwards.
Sometimes, shares are not even available to short. Although the risks are great, you may
still include short selling in your overall strategy. And if you decide to
actually short some stocks, you can try to minimize the risks by setting strict
exit prices. You could maybe set it at a 20 percent loss per investment.
If it
reaches that limit, try to fight off the urge to hang on. Remember that
successful short selling is about timing. That means you’ll want to dive into
more technical analysis.
Target
Companies
As a short
seller, you may want to target the following companies:
- · Small cap companies that momentum investors have driven up, especially companies that most find difficult to value.
- · Companies that have much higher price-to-earnings ratios than their growth rates can justify.
- · Companies that you think have bad or useless products or services.
- · Companies that are going with the flow of the latest fad or trend.
- · Companies that are expecting to have new competition.
- · Companies with weak finances, like bad balance sheets, negative cash flows, and the like.
- · Companies that rely too much on a single product.
Conclusion
There will
always be ways to earn something out of the market. Short selling lets you gain
something out of a losing company, though of course you will still have to go
toe to toe with the risks that it entails. As mentioned above, timing is the
key. If you’re still a beginner, it will be better to ask more experts or peers
to seek second opinion, or a different perspective about the security you want
to short sell.
