Shorting Strategy: Profit as Stock Market Drops
Shorting: How it Works
You might have heard the term shorting thrown around.
But what exactly is it?
Shorting is the process of selling something you don’t own with the anticipation to buy it back at a cheaper price later on.
In fact, shorting is how traders profit from stock market declines.
But exactly does it work?
When an investor holds stocks for a long period of time, the brokerage company uses this as an asset.
Brokers “lend” the shares to someone who plans to short the stock.
The trader then sells the stock at market for $100 a share, for example. You then collect this cash.
Suppose a few weeks later you can buy back the stock at $80 a share and return it to the broker.
The broker returns the security to the long term investor’s account. You profit by keeping $20 a share in your pocket.
Shorting: What Happens when Prices Increase?
Shorting is profitable for a trader that is expecting a market decline.
When the price increases, you are wrong and will lose money.
You thought the stock would drop, but instead it rips higher to $150 a share from $100.
Therefore, you are now responsible to pay back the broker the $50 per share difference.
Hence, you sold shares at $100 and have to buy them back at $150.
In reality, this “loss” you incurred is paid to the original investor who is holding to the stock for the long term.
You take the loss and return the shares to the broker. The difference is subtracted from your cash balance.
This process is called “margin lending” or “security lending” in the industry, and it is a very profitable business for brokerages.
Shorting: Not Every Stock or Security is “Shortable”
Most brokers will not let you borrow stocks to short sell if they are very volatile, or low priced.
Stocks that trade below $5 are considered “penny stocks”. Because there is a lack of liquidity and the potential for drastic price changes, it is too risky for margin lending on these companies.
Every broker has their own margin requirements for shorting stocks.
Therefore, because the broker is taking the risk they can decide to buy back and close your position at any time.
This most likely happens at at time when it will cause a loss to you, and it is one of the risks of shorting.
One of the main reasons brokers call their short positions is a lack of share available as short inventory.
Simply put, not enough investors hold the stock you are trying to short in their margin portfolios.
Shorting Strategy: ETFs
But what if you want to short an industry, commodity or stock market sector?
You can profit from your downside outlook by shorting an Exchange Traded Fund (ETF).
Every ETF is different, so you really need to do your research before making a trade.
Here is a question based process I follow for my shorting trade ideas:
- What asset do I think will decline in value?
- Which ETF mirrors the price performance of this asset the closest?
- Are there any others?
- Which ETF has the best option spreads and liquidity?
As I go through and answer the questions above I get a clearer understanding of my objective and what fits best.
Benefits of Using Options vs Short Selling
Options trading helps you minimize losses, while at the same time increasing returns.
The best part of using put options for downside bias is that your loss is limited if you are wrong.
You will also have the ability to make bigger returns with a smaller trading account size.
We have an entire course dedicated to options trading, part of every one of our subscription packages. Learn more about options trading here.
Like reading? Check out my list of the best options trading books here.
As a trader, you can be active in an up and down market. This is one of the most important aspects of being successful in the long run.
Stock market conditions change daily, and you need to adapt your trading approach.
Short selling, also called shorting is one strategy to help you profit during market declines.
Options trading using put options is even better on a risk adjusted basis.
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The information contained in this post is solely for educational purposes, and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.