Basics Of Shorting A Stock: What To Know Before You Short

by Tim P. on 2011-10-124

The responsible thing to do before we talk about shorting stocks is to offer a disclaimer. There are a lot of exciting and thrilling ways to play the stock market but more often than not, the more boring strategies work the best. Be very careful when shorting stocks. When you buy a stock, the worst thing that can happen is that it goes to zero. With shorting, there is no limit to how much money you can lose.

What Does It Mean To Short A Stock?

First, what is shorting? “Shorting” or “short selling a stock” is simply investor lingo for betting that a stock will drop in value. So what happens behind the scenes when you short a stock? Here’s what takes place: An investor borrows shares of stock from another investor and sells the stock at a certain price. Later, they buy the stock back at a lower price if all goes well. Shorting is simply buying a stock in reverse.

Does this sound confusing? It’s okay, because in actuality, you don’t have to understand how it works behind the scenes. What you’re going to do is place a “Sell Short” order with your broker (you can use a limit order although they get a little confusing when you’re working in reverse). Your broker will find the shares to borrow for you and at some point in the future, you will enter a “Buy To Cover” order, hopefully at a lower price. If you’re able to buy the stock back at a lower price than you previously sold it for, then you make a profit.

Shorting CATERPILLAR, INC. (CAT): An Example

Here’s an example. For the purposes of our illustration, let’s check out Caterpillar Inc.’s stock chart.

Caterpillar Stock Chart. How To Short

In the chart above, CAT is getting close to testing its 200 day moving average. Keep in mind that when a stock breaks below a major trend line, the stock often tends to continue to drop until it hits a support level. You can see that as early as mid to late June, CAT was only pennies away from breaking down through $95, so if it breaks the 200 day moving average, it has room to continue lower.

So suppose you decide to short the stock. You put in a sell short order for 50 shares of CAT at $97.50. $4,875 plus a little bit of commission allows you to sell those shares. Remember that since we do everything in reverse, selling is step #1. Buying it back is step #2.

Now you wait. If CAT continues to fall, and it makes it all the way down to $95, you may want to purchase those 50 shares at a cost of $4,750 plus commission. You’ll make roughly $100 (subtracting the commission) by shorting the stock.

Seems simple, doesn’t it? Not so fast. The fact is that CAT may have gone the other way. If this happens and you later have to “cover” your short by purchasing the stock at a higher price than you sold it for earlier, then you’ve lost money. For this reason, any time you short stocks, you should have a very tight stop above it.

Dealing With The Underlying Risks Of Short Selling

I adhere to the following guidelines when I short:

1. Set a stop loss order when you short. For retail investors, short selling should be a short term strategy so you should set your stop at 2% to 4% of your capital, depending on how much money you’re willing to lose. This means that you intend to get out of a position once your loss registers between 2% to 4% of what you’ve started with. I normally set stops at 2% since I always have a very specific reason for shorting. If that reason breaks down, I get out quickly.

2. Understand the risks and consider the costs of using a margin account. Also remember that in order to short stocks, you are required to have a margin account. Any time you are borrowing shares of stock, you’re doing it through margin, which means that you’re paying interest on the transaction. This is another reason why short selling should be a short term transaction.

3. Use shorting to hedge, not to predict where a stock will go. Because shorting stocks is a short term strategy and most retail traders lose money on short term strategies, it’s rarely a good idea to short a stock as a way to forecast market movement. Shorting stocks works better as a hedging strategy.

Shorting To Hedge vs To Bet Against A Stock

Hedging is simply insurance. There are world events going on that make you uneasy about the state of the market so you need some insurance. Let’s look at a very simple (and not overly practical) example of how to short stocks as a hedge. Let’s assume that you own 50 shares of Apple stock (AAPL) but you’re concerned that a big market event might send the stock market lower. You could short 50 shares of Apple. This would mean that no matter what happened in the market, you would not lose money on your Apple stock. Of course, the problem with this example is that you wouldn’t make any money either, and since Apple doesn’t pay a dividend, there would be no reason for (or benefit to) paying the commission on the short sale. Why not just sell your Apple stock and wait for better market conditions?

But what if you shorted 25 shares of Apple? That would soften the blow if the market went down. Or what if you short sold another one of your favorite technical names since we know that when a particular sector of the stock market goes down, all stocks in that sector tend to go with it? For instance, you could short Oracle or the SPDR Technology ETF while still owning Apple.

Although there are professional investors who make careers out of being short sellers, there aren’t very many of them. That’s because it’s difficult to make money when you’re shorting as a way of betting on movement. Now that you know about hedging, there are more and even better ways to hedge your positions. We discuss those hedging strategies here.

Created January 14, 2007. Updated October 12, 2011. Copyright © 2011 The Digerati Life. All Rights Reserved.

{ 4 comments… read them below or add one }

John @ Van Winkle Insurance Group October 15, 2011 at 3:02 pm

Great quick intro to Shorting. There is a ton of information through “web brokers” like e-trade and scotttrade for free. Highly advise you to make sure you have a clear understanding of hedging before you try this on your own. Great Job!

Kevin@RothIRA October 18, 2011 at 6:25 pm

The fundamental problem with shorting is that the most you can gain is 100% — which is not bad except that the amount you can lose has no limit. That makes it a heavy risk for a limited gain. Sure, you can set stop loss orders, but that also has the effect of locking in losses.

It isn’t a strategy for anything but the most sophisticated investors, and then only if they have a portfolio filled with quieter and more reliable stocks.

Trevor @ Financial Nut October 19, 2011 at 10:35 pm

Shorting stock is NOT for your casual investor. I agree that taking a short position is a great way to hedge; however, your typical investor shouldn’t worry too much about hedging a position.

If you are going to short, take some serious time to educate yourself on the risks. Remember–you have UNLIMITED downside. It’s a scary investment if the stock starts moving north.

Consider Netflix for the past couple of years. Investors and speculators alike have been saying that it’s over priced. Then they short the stock; then it keeps going up! Only recently have the shorts been able to rejoice because of some of the poor decisions Hastings has made.

Anyway–good luck. Great post.

Silicon Valley Blogger October 20, 2011 at 10:05 am

Thanks for the comments! True, there is no cap on loss here, unless you’re ready to “pull the plug” fast (on your trade). I’ve shared my own story on how I foolishly tried to short a stock on its way down. Silly me! I’ve never tried to short again — I just don’t trust myself to do it right.

What we need to remember about trading in any direction — you need to do so in a proactive vs reactive way. That is, you need to plan your moves well and need to do it rationally, with a clear head, rather than out of fear or any other emotion. Try not to make investment decisions when you’re frustrated, upset or worried.

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