Shorting any stock is very risky, but there is money to be made if you know what you’re doing.
Selling a stock short is not for the faint of heart, however short selling stocks can definitely make you some good money. If you know how to short a stock and make money, the market does not always have to up in order for you to profit. This post will cover the basics of selling stocks short, associated risks with short selling stocks and a few tips on how to make money shorting stock.
What is short selling of stock?
To profit from a decrease in the price of a stock, a short seller borrows the shares and sells them, expecting they will be cheaper to buy back in the future. The owner is not notified the shares are loaned to the short seller, but this action does not impede the owner from selling at any time.
When you short a stock, you are basically betting (or know for sure) that the price is going down. It is important to note, that the shares are loaned to the short seller at one price in hopes they are cheaper to buy back in the future. Another way to look at it would be the short seller is borrowing the stock at one price and promising to deliver it to a buyer at a point in the future, at which time they’d have to buy-back the stock.
Here’s an example: Let’s say I want to short 100 shares of Microsoft (MSFT) which is currently trading at $50. I make the request through my broker, the shares are sold from their inventory (or the inventory of another account) and the proceeds are credited to my account. At some point in the future, I will need to “close the short” which means I need to buy-back the stock which means purchasing the same number of shares and returning them to the broker. If the price drops, I can purchase the same number of shares and be left with money in my account meaning I made a profit. However, if the price goes up, I am still obligated to purchase the same number of shares (at a higher price than before) and I will lose money.
The Risk of Shorting Stocks is Infinite
While the amount of money you can make shorting stocks is capped at the original price you paid for the shares, the potential loss is actually infinite as theoretically, the price of a stock could keep going up for ever. Think about if you short 100 shares of a stock that is trading for $50. The stock never goes down and now is trading at $60/share. You’d have to spend an extra $1000 to cover your short. If you still think the stock is going down, but it goes up another $10/share, you’re not out $2000 and this could continue on forever as long as the stock keeps going up. For this reason you will usually be required to have a margin account if you want to short stocks.
What Is A Margin Account For Stocks?
A brokerage account in which the broker lends the customer cash to purchase securities. The loan in the account is collateralized by the securities and cash. If the value of the stock drops sufficiently, the account holder will be required to deposit more cash or sell a portion of the stock.
So really, when you are using margin to trade stocks, you are not using your own money, but the assets of your broker. In a typical margin account scenario, the buyer may fund his account with 50% of the total value he wishes to trade with and the broker will borrow him the remaining 50%. Margin accounts are not for everyone and beginners should definitely shy away from them as both gains and losses are amplified when trading on margin.
What are the minimum margin requirements for a short sale account?
Technically speaking, Under Regulation T, the Federal Reserve Board requires all short sale accounts to have 150% of the value of the short sale at the time the sale is initiated. There are several other types of margin requirements such as maintenance margin which can be read in-depth here.
Things To Think About When Shorting Stocks
Like we said, shorting stocks is a risky business. Couple that with margin accounts and we’d rather leave it to the professionals. However, let’s just look at the risk associated with shorting a stock. Like we said, shorting a stock can theoretically result in huge loses (infinite). If you short a stock at $10 and it runs up to $300 you’d be out 30x your initial investment. Brokers would probably issue a margin call before this happens, but it just shows that shorting stocks carries huge risks.
Researching The Stock
Finding the perfect stock to short is not an easy task. The process of finding shares to short is called a “locate”. If your broker can not find the shares, you can not short the stock. This happens because not all stocks and shares are easy to borrow. This happens when the underlying stock is not held by a large number of investors or that there is already a large short position in the stock. You can also not short a stock under $5 or one that recently had an IPO.
You should set your own liquidity requirements when shorting stocks. If the price moves in a unfavorable direction you may want to unload it quickly. Therefore you’ll want a stock with millions of shares available and that has a decent daily average volume. If the price goes down, you’ll want to liquidate and get your money out. Liquidity should be a primary factor when evaluating a stock to short.
Existing Short Positions
How many people are already shorting this stock? If the answer is a lot meaning there is already a large short position in the stock, the bad news may already be priced-in to the share price and not much room left for the price to drop even further. As a rule of thumb, if you’re late to the party don’t try crash it.
Margin Account Requirements
Remember, to short stocks you will need a margin account. You will typically have to fill out an online application to obtain a margin account for shorting stocks so don’t expect to get this opened immediately. Margin accounts are borrowed money – remember this at all times.
Also, you do not get to collect interest on margin accounts, but you may get charged interest. Know what you’re doing if you plan to trade on margin.
Let’s say you shorted a stock and it starts moving up…NOOOOOOO….. you’ll need cash to meet the margin calls and you may need to pay these daily. If you do begin losing money, your broker will probably require you to put more cash into your account – typically enough to cover the purchase of the stock on the open market at the current price.
If you don’t deposit the extra cash to meet the margin calls, your broker will end up selling the securities to meet the call and you may get your margin account suspended.
Remember, when you short a stock you are borrowing the shares. This means that if the owner of the shares decided to sell them you’ll need to replace them either by finding additional shares or buying them on the open market.
A short squeeze is a market event when a stock price rises quickly which causes those traders who have a short interest in the stock to “cover”. Covering a short means the trader buys the stock in the open market to repay the shares they borrowed. When a short squeeze happens, the price of the equity goes higher since there are more buyers than sellers.
You will see a short squeeze at times when there are certain market events like earnings reports that differ from analyst opinions or various news items.
Here’s another example of shorting stocks
Short selling is a risky to profit on declining stock prices. It is a way to bet that the stock will go down in price. When you buy a stock, you expect it to go up. When you short a stock, you expect the price to go down. Someone who is “long” a stock is holding it in hopes the price rises. Someone who is “shorting” a stock is betting the stock price will go lower.
For example, Paul has been researching a bank that is in financial trouble and is expecting their stock will go down because of those financial difficulities. In order to profit from his prediction, Paul will “short” the bank.
So how does this actually work? Paul calls his broker and tells him that he wants to short 10 shares of the bank. To this, the broker needs to find ten shares to lend to Paul. The broker can look at their own inventory, shares from other brokers, or his client’s portfolios in order to find the shares to lend to Paul.
The broker will then sell that share on the open market for Paul at which time the proceeds of the transaction are deposited into Paul’s account. Paul was right, and after two weeks, the stock price drops by 30% of the price at which the broker sold it at the beginning of the short.
Now, Paul thinks that a 30% gain is pretty awesome, so he calls his broker and tells him to cover his position in the bank. The broker uses the money from Paul’s brokerage account to buy-back the ten shares Paul borrowed and then returns the shares to the portfolio from which they were borrowed. Since the price is now lower, Paul is left with the 30% difference in price as cash in his brokerage account.
This type of trading is for advanced and experienced traders because it is extremely risky. Unlike buying a stock and going long, losses are unlimited when you go short. If you buy a stock for $100, the most you can lose is $100 – that would mean the company goes out of business and the stock price went back to zero.
In a shorting situation, the price of the stock could theoretically to up forever. This means if you borrowed a share of stock for $100 and you were wrong – the price went up, you would have to cover your short at a higher price, which, in theory, could go on forever.
While shorting is an effective way to make money when prices go down, you need to use stop prices in order to mitigate your risk. Effective use of shorts, stops and limits come with practice and experience. We suggest if you want to get into short selling stocks, you practice with fake money until you feel comfortable with your picks.
Advice When Trading on Margin
The way a margin stock account works is that you have a specific amount within the account and you are borrowing more than you have from the brokerage. Your plan is to take this additional money and invest it in hopes of higher returns. On the flip side, if the account declines and you lose money, the brokerage will invoke a “margin call” which ensures they will get their funds back.
Typically in the U.S. the level that has been set is 50%. Which means you have to have about 50% of the investment in cash in order to cover that investment.
Margin accounts have higher requirements than your typical brokerage account. It’s not like you can just go to eTrade or TD Ameritrade and open a margin account in ten minutes. A margin account will usually require you to fill out additional paperwork, they will look at your investment history and ensure you are experienced and end up losing your money (and the brokerage’s money).
Margin Calls Explained
In the last few paragraphs, we’ve mentioned the idea of margin calls several times. Most people in the investment arena never want to hear the words “margin call”. When an investor hears these words, it typically means your investment has gone south – you’re losing money! It also means that your margin line (or the amount you have borrowed) is now due or payable.
Traditionally when you are issued a margin call, you have 24 hours to find the money and pay it. If you don’t, they will sell your investments.
So, how do we end up in a margin call? Well it all happens when you opened your margin account and decided to buy shares on margin, thus, using the shares as financial security.
Because the lender is borrowing you the money based on the value of the share price, he will set a buffer (margin call territory). If the price jumps $30 all is good. However, if the share price drops, the broker wants to maintain his buffer and will issue a “margin call” in order to maintain their level of safety on the margin or loan.
If you drop below the lender’s level of comfort, they will issue a margin call. Let’s say the share price drops $30 on a $100 stock. The borrower could issue a margin call which means you need to add some cash to your margin account to get the total value of the account back up to a level that the broker is comfortable with.
If you do not come up with the money, the lender can sell your shares – this is not good because who wants to sell a stock when it has declined (especially if you think it can go back up).
Try not to borrow aggressively and do plenty of research before you buy on margin. Avoid paying interest on interest, diversify and make sure you pay your interest bill every month.