How To Short A Stock The Right Way (And Why You Should Be Careful)
When we talk about investing, 99% of the time we focus on the “long” side of the market.
It’s understandable. We’re naturally conditioned to want to bet in favor of something, rather than against it.
Betting against stocks is no different. It won’t win you any popularity contests, but it is a viable strategy that you can use to profit.
For most, if you want to bet against a stock — options are the way to go. But if you simply want to have a better understanding of how shorting works, let’s dive in…
Shorting a stock is as easy as going “long” a stock — once you understand the basics.
When investors go long, it means they’re buying shares of a stock in the belief that the price of shares will rise over time. If and when they do, they’ll ideally sell the shares back to the market at a later date for a higher price than what they paid. If they’re wrong, they’ll sell the shares back for a loss.
When investors short a stock, the same thing happens, but in reverse. A trader will first sell shares of a stock by borrowing the shares from their broker, anticipating the share price will drop. If that happens, they’ll turn around and buy these shares back for a lower price and return them to their broker.
So instead of buying, owning, and selling shares… you first borrow, then sell, and then buy back (or “cover”) shares.
There are few other key differences to take note of, however, and you need to understand the risks involved. One aspect of shorting that often scares investors away is the idea of unlimited downside. Let me explain…
When you take a long position on a stock, your downside risk is limited. For example, if you bought a share of XYZ stock for $50, then the worst that could happen is the stock price moves to $0. Now, a 100% loss on your investment. Sounds awful, right?
When you sell a stock short, the share price could rise to $55, $70, $100 and higher — all the way to, hypothetically, infinity. Since there is no limit on how high a stock’s price can go, short sellers theoretically have infinite downside potential.
Sounds scary, right? This is probably the single biggest reason why most investors who understand shorting stocks don’t do it.
But if you implement a few simple strategies, then you can capture solid returns and mitigate unnecessary risk. (Honestly, you should probably consider using what I’m about to tell you whether you’re going long or short.)
Mitigating Downside Risk
First step: cut your losses. A 25% loser will mathematically require a 33% gain just to break even. If you let a loser fall 50%, then you have to make a 100% gain in order to get your money back. It gets worse the longer you let your losers ride. By cutting your losses, you’ll never have to face that daunting task of picking the next triple-digit winner just to get back to square one.
The best way to do this is by using either a hard stop-loss or a trailing stop.
Let’s look at an example…
Let’s say you decide to implement a 20% trailing stop loss on that XYZ stock you bought at $50. If the stock hits at $40, then a sell order will be entered automatically, getting you out of the stock. It’s a different animal if you choose to use a “mental” stop-loss instead of using one through your online broker. It’s up to you to decide whether you have the self-discipline to actually carry this out on your own.
However, if the stock rises to, say, $60 after you buy, then your trailing stop moves up with the price of the stock. So now your new exit price would be $48 (20% of $60 is $12, $60 – $12 = $48).
This process works the same for when you short stocks. If you short a stock at $50, then be prepared to buy to cover your position if and when the stock reaches your breaking point. The percentage that you decide on is up to you. But the important thing is that this gets you thinking about how much of a loss you are willing to accept before you find out later, when it’s much more painful.
As a rule of thumb, if you are buying a stock that tends to be more volatile, then you may want to implement a wider stop-loss.
Whatever stop you decide to use… a hard stop at a specific price, a trailing stop, a “mental” stop… it doesn’t matter as much as actually implementing the stop. Following your exit strategy is key.
Next, you should always remember to use sensible position sizing. (That means don’t bet the farm on one short trade.) Again, this applies whether you’re going long or short. But since the hypothetical risk is elevated with going short, this is all worth repeating. Whether you’re shorting stocks or going long, this is something every investor should implement in their portfolio.
As I referenced earlier, shorting stocks is something that should not be taken lightly. Frankly, it’s the kind of thing that may only be appropriate for seasoned investors a handful of times a year, or ever.
For most investors who want to bet against stocks, buying put options is a much better alternative. That way, the downside is limited only to what you risk upfront. (We’ll save discussing how buying puts work for another day, however.)
But hopefully this gives you a better grasp of how this works, and you can decide for yourself whether it’s appropriate for your own portfolio.
Editor’s Note: If you’re looking to profit from uncertainty and bet against stocks the right way, I suggest you heed the advice of my colleague, Jim Pearce.
Jim doesn’t worry about market mayhem… he makes money from it. Thanks to his under-the-radar strategy to flip market mayhem into fast payouts, he’s put together an impressive track record. Want to learn more? Click here now.