New market participants often think that the only way to make money is to the upside if the stock market goes up investors, traders, anyone who has market exposure is winning! That is a misconception because we can make money on the downside. It’s called short selling, you can short sell stocks and other assets to take advantage of markets moving lower. It’s often a harder concept to grasp but it gives you yet another tool for your arsenal.
What does short selling stocks mean? It’s the act of selling the stock and making money as the stock drops, you then buy the stock back at a lower price and collect the difference. Market participants usually do this when they anticipate a decline in an asset price, which is perfect in downward markets like the 2020 financial crisis. It’s tricky though, how do you sell something you don’t even have? To short sell a stock you have to borrow that stock from someone, in this day and age it’s your broker, you put up margin to borrow the stock shares from your broker. You borrow the stock, sell the stock, buy it back at a lower price (ideally) and return the stock to the lender. Short selling is done for either speculative purposes that you will make again on an asset decline or you want to hedge a current long position you have.
The short seller will often borrow from their dealer-broker as mentioned before and look to profit from those shares before they should be returned to that broker. The margin account will have to be used for the most part and will have to pay interest on the value of the shares that they borrowed to sell as long as the position is open. There are rules for the margin that must be maintained in the account in the US and in other countries too, which means that if the account value falls under maintenance margin. Or the stock price rises instead of falls by a certain amount, the short seller has to deposit more funds or they risk being blown out of the position by the broker. After the market participant buys back the shares for a lower price and returns them to the lender, the interest is then paid. This is all done automatically within the broker software in this day and age.
Here is an example. If you believe that TSLA (Tesla) is overvalued and you want to short sell it. Believing the price will drop in the coming weeks to months. If you’ve done your analysis and the current price as of April 16, 2020 is $745.21 and you think it has the potential to at least drop down to $600 by August you would look to short sell the stock. You then borrow 100 shares and sell them to market participants, so you are now short 100 shares of Tesla at $745.21. Note that you may not always get a fill on all the shares you want to short, maybe there isn’t that many out to borrow or if it’s a heavily shorted stock you may have to accept a less favorable price.
In a month’s time, if the price falls down to $620, you make a good chunk of money! The profit of that position is ($745.21-$620)*100= $12,521. This is a great profit if you have the capacity and margin to be able to afford 100 shares that is because Tesla is an expensive stock! This is the profit that doesn’t include what interest you may be charged and commission for the position.
However, it’s not all roses and sunshine in the short trade world. You have to understand the risks that come with this approach. Short selling stocks is a technically infinite risk because a stock’s price can rise forever. Before this happens you will get multiple margin calls and the broker will blow you out. So what would the risk be in this scenario and how can you cap that risk? The risk is if the stock price rises. So if Tesla ran up to $800, if you had not been margin called already your loss would be the following.
($745.21-$800)*100=-$5,479. A loss of nearly $5,500 on this position. This can be mitigated by using a stop loss based on your account. If you are willing to risk a 2:1 reward to risk. Based on the above potential profit then the risk you could take on this position is roughly $6,250.
There are many pros and cons that are associated with short selling stocks.
| PROS | CONS |
|---|---|
| Capitalize on the downside | Unlimited losses |
| High-profit potential | Margin account needed |
| Little initial capital requirements | Margin interest paid out |
| Leveraged investments | Short Squeeze |
| Hedge |
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There are alternatives to short selling stock that may be less stressful and less risky. Where the losses are capped. Those are derivatives, options and futures contracts. In the options market you can capture the downside without having to risk a lot and capping your risks at that. Put options let you buy contracts that appreciate when an asset drops. While shorting futures markets theoretically holds infinite risk and you have to put up margin to enter into the trade, you can do so with little margin and cap your risk with stop losses.
If you want to learn more about derivatives check out TRADEPRO Academy. Take advantage of the market to the downside.
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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 for your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.
