A stock market is a place of high action and risk, and only a select few truly capitalize on all their opportunities. The best stockbrokers have enough tricks and strategies to take calculated risks, go with the minority, and profit off rare occasions. As a stockbroker, one of the most crucial strategies you need to learn how to short stocks.
What is Short Selling?
Short selling is a process where an investor borrows a security (stock, bond, or any other security) whose price they expect to fall soon. They sell the security in the open market, wait for the price to fall, and when it does, repurchase it at a lower rate, and return the security to the owner. The difference in prices is the investor’s profit.
To open a short position, you must have a margin account with a minimum balance. To close a short position, you return all the securities you borrowed and account for any interest charged by the broker or commissions charged on trades.
Advantages and Disadvantages of Short Selling
The advantage of short selling a stock – assuming you predict the downward price trend correctly – is that you can make profits with a small initial capital. Since you use a marginal account, you can also carry out leveraged investments on the side.
However, if you predict wrongly, there is potentially an unlimited loss for you, since there is no cap for how high the price can go. If there is a lack of supply but excess demand for a particular stock due to other short-sellers covering their positions (this is called a market squeeze), you can get into trouble here as well. Moreover, during the time you wait for the prices to drop, you have to pay interest on the borrowed money.
Short selling is a high risk-high reward investment that most new traders avoid. If you do plan do execute such trades to make profits, here are some strategies that you should know.
Ideal Conditions for Short Selling
The typical trend is that stock prices decline at a much rapid rate compared to their increase, so you have to be alert enough to find the perfect time window to sell your stock short. Entering a short sale too early or too late involves much more uncertainty. Here are some scenarios where the odds of successfully carrying out a short sale improve.
1. Bear Market
A bear market is characterized by falling stock prices, usually over 20% of the recent highs. This situation is ideal for short-sellers since the prices of all the stocks are dropping. There were plenty of short-sellers who took home a fortune during the 2008 global financial crisis.
2. Deteriorating Stock Fundamentals
When stock fundamentals decrease due to slowing revenue or profit growth, increasing challenges to the business, or other reasons, these are early signs of a bear market. Some stockbrokers prefer to wait until the bearish trend is confirmed, while others commit early to make the most of the first-mover advantage.
3. Short Selling Metrics
Two metrics that are most commonly used to track the short-selling activity on a stock are the short-interest ratio (SIR) and the short interest to volume ratio. Both metrics indicate an overall bearish or bullish market sentiment, based on which investors can make decisions.
SIR is the ratio of the shares currently shorted to the shares presently available for floating in the market. A high SIR indicates a stock that is overvalued, whose price is likely to drop.
The short interest volume ratio is also known as the days to cover ratio. It is as the total shares held short divided by the average daily trading volume of the stock. A high value for this metric is a bearish indication.
Short Selling Strategies
1. Short the Weakest Market Sectors
It is easier to identify downward trends in weaker market sections and use countertrend bounces (strategies where you go against the existing market trend) to make short sales. Such stocks are also less vulnerable to market squeezes, minimizing your risk as well.
For a similar reason, it is best to avoid the stocks which are always in the news (for good or bad). These stocks attract a bigger trader crowd, which, in turn, increases the short interest and raises the chances for market squeezes.
2. Never Sell When the Volume is Low
When you plan to sell a stock short, make sure the volume of trade for that stock is high. It is a rule of thumb not to short sell in a “dull market,” i.e., where the volume of trade is low because the conditions do not follow the usual trends of demand and supply. For example, avoid short sales during holiday seasons like Christmas week for this reason.
3. Breakeven Price
The lower the price of a stock, the higher your profit. However, the moment you see the share enter a profit curve again, you should be vigilant because you don’t stand to win much once the profits begin. In such a case, you can buy the stocks immediately or wait till the price reaches a breakeven value, but no longer than that.
4. Sell a Pullback in a Downtrend
A pullback is a marginal drop in the stock prices from a recent high, usually lasting for a short time before an uptrend begins. After a rise in prices, a pullback is typically a sign of trend reversal, which should prompt you to buy back the stock. Pullbacks are only temporary because the underlying stock fundamentals do not change much.
Open a Virtual Account Today
Most of the stock trading concepts seem simple when reading, but turn out to be far more complicated when you face the same situation in real life. Not all strategies and secrets are openly available, either. Practice and learning from experience are crucial to becoming a professional stockbroker, and no one who made it big did so in any other way.
Luckily, you can get an excellent sense of how the actual market works by signing up for a free brokerage account on virtual stock trading platforms. You can trade stocks and practice your strategies here without losing any real money.