If you believe what goes up must come down in the stock market, you should learn how to short a stock. Stock prices fluctuate throughout the day, but trends are based on fundamentals.
When the fundamentals are bearish, there is potential to profit from falling stock prices. This is where short selling comes into play. Short selling is a risky endeavor and not suitable for everyone. In this article, we’ll take a deep dive to answer the question, “What does it mean to short a stock?” and “How to short stock.” Get GameStop alerts:Sign Up
We’ll cover the nuances and the safeguards to prepare you for the various outcomes so you can enter with your eyes wide open.
Key Takeaway
Shorting a stock means selling shares at a higher price and buying them back later, preferably at a lower price, for a profit. Short shares are borrowed through your broker and returned to the owner when you cover or close the position. Just as you may have reasons that a stock price will rally higher long term, you can also have reasons a stock will fall soon.
Understanding Short Selling
Let’s take a minute to understand what it means to short sell stock. This can be a bit confusing if you are learning about short selling. Traditionally, investors buy stocks, which is a long position. They hope the shares will rise in value to profit from buying low and selling higher. If the stock price falls lower than where their long entry is, then the position loses money.
Short selling is the opposite. You are selling the stock first, also known as going short. You are hoping for the stock price to fall so you can buy back the shares to close out the position, also known as covering the shorts. The difference between the price you sold and the price you bought back is your profit. However, if the stock price rises, then you lose money.
Short-selling is riskier than going long because the losses can be unlimited. When you are long a stock, it can only fall to zero, and you lose your investment. However, when you sell short, the stock can rise indefinitely, causing your losses to mount to the point where you can lose many times your investment.
The Mechanics of Short Selling
While it may seem strange to sell a stock you don’t own in your account, it occurs behind the scenes through your broker and clearinghouse. When you buy and own a stock, you usually don’t ask for the paper stock certificates to be mailed to your home. Instead, they stay in a digital format at the clearinghouse. This enables fast buying and selling as the shares are transferred digitally without shipping certificates by snail mail. The clearinghouses are the custodians that hold and transfer stocks.
Before you can sell short a stock, your broker must be able to borrow the shares. Not all stocks are borrowable, which makes them shortable. The stock must be borrowable to be loaned out for you to sell. Your broker works through the clearinghouse that holds the shares to get them to lend you the shares to sell. The owner of the shares doesn’t know when their shares are borrowed. Some brokers have programs where stockholders can lend their shares and receive a fee. You can execute short sales once you have the shares on loan in your account. Short-selling blue-chip stocks in various sectors, like the consumer discretionary sector, help to ensure liquidity with less chance of a short squeeze.
Executing the Short
You would short sell the stock on the open market to execute a short trade. Usually, you can sell the stock at the bid or place it on the ask to get a better price. However, if the stock becomes short-sale restricted, you will have to wait for an uptick to short. This means you will usually place a limit order on the inside ask. Once the trade executes, you will receive a confirmation. Your account should show a negative stock position, indicating a short position.
Reasons for Short Selling
There are many reasons for selling short stock. They fall into two categories: fundamental and technical, like fundamental and technical analysis. Fundamental reasons are broad-ranging and have to do with any negative news, events, sentiment or information that can cause the stock price to fall. Technical reasons are strictly based on chart patterns and setups. A combination of fundamental and technical reasons can help comprise your thesis for shorting a particular stock.
Fundamental Reasons
Fundamental reasons are based on a company’s financials, products, services, management, news, judgments, competition, rumors and virtually anything that doesn’t have to do with charts.
A bearish macro market sentiment, sector weakness or a potential black swan event can be valid fundamental factors. For example, if XYZ reported a weak quarterly earnings report and lowered its full-year revenue and earnings forecasts, this could be a short-selling opportunity.
Technical Reasons
Technical reasons solely pertain to bearish chart patterns and setups for stock shorting. Technicians believe that the chart patterns tell the true story of a stock since they represent the actual buying and selling of shares. Charts are like the footprints left behind by dinosaurs. Traders understand that dinosaurs can’t walk in the sand without leaving footprints. Stock prices move solely based on the buying and selling demand. Here are some bearish technical patterns considered for short sellers:
Bear flags: Bear flags are formed after a steep price drop forming the flag pole. The stock bounces in a parallel channel rising channel forming the flag. The breakdown occurs when the stock falls back under the lower flag trendline.
Head and shoulders: Head and shoulders comprise three peaks and a neckline trendline. The first peak forms on the first high that shapes the left shoulder and pulls back down to form the neckline when it bounces again. The next bounce surges higher through the left shoulder level to form an even higher peak: the head. The stock pulls back again and bounces to continue the neckline. The next bounce rises to a lower high, forming the right shoulder.
Inverse cup and handles: Inverse cup and handles are formed when a stock makes a bottom and bounces until it falls back down to the same bottom level again, forming the cup lip line. The handle forms on a shallow bounce that falls back down through the lip line, triggering the breakdown.
Descending triangles are comprised of a descending (falling) trendline, which represents low peaks (tops) on bounces, and a flat-bottom trendline meeting at the apex. The breakdown occurs when the stock falls through the flat-bottom trendline.
In the daily candlestick chart of HRL, the descending trendline forms at the $32.73 peak as shares cascade lower. Each bounce attempt peaks at a lower high. The flat-bottom trendline at $30.15 is formed by the multiple bounce attempts at that level as bulls attempt to deflect breakdowns.
Eventually, the descending trendline and the flat-bottom trendline get closer to meeting at the apex point. A breakdown triggers ahead of that when the stock collapses under the $30.15 flat-bottom trendline, sending shares to a low of $28.51.
How to Short a Stock in 5 Steps
First, you must have a margin account with an online broker.
Step 1: Research to identify a viable short-stock candidate.
You may already have a stock in mind to short. You can also use a stock screener or a list of stocks to short on Marketbeat to search for potential candidates. Be sure to do your fundamental research and your technical research. It involves developing a thesis on why you believe the stock price should fall.
For example, you may believe that AI investments are overvalued. Be aware that the market isn’t always very logical, and even overvalued stocks can continue to climb higher. Be sure to identify chart patterns, support and resistance levels to use them as potential price targets and, most importantly, stop-loss levels.
Step 2: Confirm that the stock is shortable.
Check to see if the stock is shortable at your brokerage. You can do this by placing a mock short-limit order a few dollars away from the bid price so you don’t have a chance to get filled. If it’s not shortable, it should immediately warn you that the order can’t be put in. Some stocks are not shortable because the shares can’t be borrowed due to limited liquidity or high volatility.
In instances where the stock is shortable, but there are no shares to borrow, you can contact your broker through your platform or via chat, email or phone and ask them to “locate” shares. Some stocks are hard to borrow (HTB) because the float may be small. Your broker may be able to locate shares to borrow for you to short, but it will cost you money. HTB stocks can be expensive to borrow and are very dangerous as they can be short-squeezed.
Step 3: Place your short-sale trade order on your brokerage platform or app.
Depending on your broker, you will have to click a tab or button that says, “Short sell to Open,” “Short” or “Sell” to place the short sale order. You can place a limit price where you would like to short the stock or select a market order which will immediately fill your order on the bid price. Once you have selected the quantity and the short order, review it, click the confirm button and wait for confirmation. Once the trade is filled and executed, proceed to the next step.
Step 4: Monitor and manage the position.
Watch the price action closely and always be mindful of any changes to your thesis for the short position. If the stock starts to rise or fall, be aware of your price targets and stop loss levels. Since you are paying margin interest for holding short positions overnight, it’s prudent to capitalize on sharp price moves down.
Step 5: Close out your position.
You will have to close out your short position eventually. Remember that you are paying margin interest and potential fees on the short position if it’s an HTB security. That’s why keeping most of your short…
