So how does shorting work? Basically what you are doing is borrowing shares from your broker and selling them at current market price to another buyer in hopes of buying them back (or covering) at a discount in order to return the borrowed shares to the lender and keep the difference, which is your profit. So, let’s say you short 100 shares of ABC at $10 a share. So, you’ve borrowed 100 shares, sold them at the market price of $10 and your account would be credited $1000. If the stock falls, you can buy the stock back at a cheaper price, repay the broker the shares you borrowed and pocket the difference. So, let’s say the stock falls to $8/share and you buy the shares back (called "covering"). You pay the $800 dollars for the 100 shares, give them back to your broker and you get to the pocket the difference ($1000 – $800 = $200). However, should you have to cover above $10/share, you will need to use additional funds in order to buy the shares back that you owe to your broker (you lose money!) Here a few things to keep in mind when selling short:
** You must have a margin account to short stocks, for which you will be charged interest
** Avoid shorting stocks with large dividends or avoid shorting during the ex-dividend date – you pay the dividend
** Short stocks with good liquidity (at least a few hundred thousand shares)
** Avoid shorting stocks that are already heavily shorted to avoid being caught in a short squeeze. A short squeeze happens when a large number of short traders attempt to cover their position at the same time, driving up the price of the stock quickly. This is a another reason for sticking to stocks with good liquidity. If caught in a short squeeze of a stock with poor liquidity, you could get slaughtered because there would be few shares available to purchase in order to cover your short position. Usually, news in the market will trigger a short squeeze, but sometimes traders who notice a large number of shorts in a stock will attempt to induce one. The importance of liquidity can be felt here too, since the greater the number of shares traded in a stock, the less susceptible it is to manipulation by a single investor or small group of investors. You can gauge the amount of short selling by checking the short interest in a stock which is expressed as a percentage of shares sold short (calculated by dividing the number of shares short by total shares outstanding). Of course, the higher the percentage, the greater the short interest. In addition, the short interest ratio, which is the number of shares sold short divided by average daily volume can indicate the amount of short selling in a stock. This number is commonly expressed as "days to cover". The higher the number of days to cover, the greater the likelihood of a short squeeze. I have found www.shortsqueeze.com to be a good source for this information.
** Your broker may force you to cover the trade if it can no longer lend the shares to you (ie. the lender wants his shares back so that he can sell his position). This is one big pitfall of short trading and can force you out of a trade long before you are ready and profitable! If I were to take a guess this happens probably 10% of the time.
** I don’t buy the argument that shorting is extremely risky – it’s based on the notion that stocks can rise to infinite levels (meaning your losses could be infinite), whereas in a long trade your losses are limited because the stock can’t go lower than zero. Sure, your losses can be endless in a short trade… if you let them!! Just as with a long trade, it’s critical to practice sound money management by keeping losses small!
** Look for smaller profits in short trades (typically 10 – 20%), with the profit target near the next level of support.
In a future post I’ll have a look at the trade setups I use for shorting stocks. You can certainly see the kinds of charts I look for in good shorting opportunities in past trades of the day, but I’ll go into a bit more detail. If there is anything that I may have left out in this mini guide feel free to post a comment.