This strategy isn’t a bad way to make money, especially because, if the country’s economy continues to grow even a little bit, businesses are going to grow and so are their stocks.
But even in a good economy, some securities go down. The company may be mismanaged, it may sell a product that’s out of favor, or maybe it’s just having a string of bad days. For that matter, maybe it went up a little too much in price, and investors are now coming to their senses. In these situations, you can’t make money buying low and selling high. Instead, you need a way to reverse the situation.
The solution? Selling short.
In trading lingo, when you own something, you are considered to be long. When you sell it, especially if you do not already own it, you are considered to be short. You don’t have to be long before you go short.
Most brokerage firms make selling short easy. As a day trader, you simply place an order to sell the stock, and the broker asks whether you’re selling shares that you own or selling short. If you place the order selling short, the brokerage firm goes about borrowing shares for you to sell. It loans the shares to your account and executes the sell order.You can’t sell short unless the brokerage firm is able to borrow the shares. Sometimes, so many people have sold a stock short that no shares are left to borrow. In that case, you have to find another stock or another strategy.
When the shares are sold, you wait until the security goes down in price, and then you buy the shares in the market at a bargain. You then return these purchased shares to the broker to pay the loan, and you keep the difference between where you sold and where you bought — less interest, of course.You can earn interest on the money you receive for selling the stock, and investors who are active on the short side of the market figure this into their returns. However, day traders don’t hold on to their positions long enough to earn interest.
The stock exchanges are in the business of helping companies raise money, so they have rules in place to help maintain an upward bias in the stock market. These rules can work against the short seller. The key regulation is what’s called the uptick rule, which means you can only sell a stock short when the last trade was a move up. You can’t short a stock that’s moving down.
The figure shows how short selling works. The trader borrows 400 shares selling at $25 each and then sells them. If the stock goes down, she can buy back the shares at the lower price, making a tidy profit. If the stock stays flat, she loses money because the broker will charge her interest based on the value of the shares she borrowed. And if the stock price goes up, she not only loses money on the interest expense but also is out on her investment.
The interest and fees that the broker charges those who borrow stock accrue to the broker, not to the person who actually owns the stock. In fact, the stock’s owner will probably never know that his shares were loaned out.
Choosing shorts
Investors — those people who do careful research and expect to be in their positions for months or even years — look for companies that have inflated expectations and are possibly fraudulent. Investors who work the short side of the market spend hours doing careful accounting research, looking for companies that are likely to go down in price some day.Day traders don’t care about accounting. They don’t have the time to wait for a short to work out. Instead, they look for stocks that go down in price for more mundane reasons, like more sellers than buyers in the next ten minutes. Most day traders who sell short simply reverse their long strategy. For example, some day traders like to buy stocks that have gone down for three days in a row, figuring that they’ll go up on the fourth day. They’ll also short stocks that have gone up three days in a row, figuring that they’ll go down on the fourth day. You don’t need a CPA to do that!
Losing your shorts?
Shorting stocks carries certain risks because a short sale is a bet on things going wrong. Because, in theory, there’s no limit on how much a stock can go up, there’s no limit on how much money a short seller can lose. Two traps in particular can get a short seller. The first is a short squeeze due to good news; the second is a concerted effort to hurt traders who are short.Squeeze my shorts
With a short squeeze, a company that has been popular with a lot of short sellers has some good news that drives the stock price up. Or, maybe some other buyers simply drive up the price in order to force the shorts to sell, which is a common form of market manipulation. When the price goes up, short sellers lose money, and some may even have margin problems. And the original reason for going short may be proven to be wrong. Those who are short start buying the stock back to reduce their losses, but their increased demand drives the stock price even higher, causing even bigger losses for people who are still short. Ouch!Calling back the stock
All is not sweetness and light in the world of short selling. Many market participants distrust those folks who are doing all the careful research, in part because they are often right. Company executives are often optimists who don’t like to hear bad news, and they blame short sellers for all that is wrong with their stock price. Meanwhile, some short sellers have been known to get impatient and start spreading ugly rumors if their sale isn’t making money.Many companies, brokers, and investors hate short sellers and try tactics to bust them. Sometimes they issue good news or spread rumors of good news to create a squeeze. Other times, they collectively ask holders of the stock to request that their brokerage firm not loan out their shares, which means that those who shorted the stock have to buy back and return the shares even if doing so makes no sense.