Most people are familiar with the traditional stock market wisdom of ‘buy low, sell high.’
But did you know that there’s actually another way that traders can profit? And it’s by moving in the opposite direction — buying high and selling low. It’s called short selling.
While this might be a new concept to you, short selling isn’t new at all. This method of trading has been actively used in the U.S. markets for over 100 years.
In this post, I’ll explain what short selling is, how it works, and some key considerations to remember when exploring this trading style.
What Is Short Selling?
Short selling is a method of trading where you specifically seek out trades where you think the stock will lose value, looking for momentum from the price decline.
How Does Short Selling Work?
When you enter into a trade as a short seller, you actually borrow shares from your broker, rather than buying them. Then, you sell those borrowed shares, taking a negative position.
So, if you have 1,000 shares, your account shows ‘-1000 shares’ (yep, that’s a negative sign). To complete the short-selling cycle, you then need to buy back the shares so you can return them to your broker.
Here’s the idea: If the stock drops in value, you can buy shares back at a lower price. Your profit is the difference between the higher price at which you sold and the lower price at which you bought.
In short (pun intended), you’re still buying and selling shares of a stock — it’s just kind of done in reverse.
Is Short Selling Legal?
Short selling sounds a little shady from the outset, but it’s actually a time-honored tradition.
This trading technique actually dates back to the 17th century in the Netherlands, and it’s been used in the U.S. markets for over a century!
It’s not illegal, nor is it unethical.
What Should You Look for in Stocks to Short?
What are some signs that a stock might be a contender to short? Here are some common characteristics:
- Stocks that are up without a strong news catalyst. These are sometimes called ‘pump and dumps.’ They’re often inflated without any good reason and are set for a downfall.
- Stocks with prices driven up by momentum investors. Stocks like this can be hard to value and could dip in price.
- Sympathy stocks. Sometimes, if one stock goes up, other stocks within the sector can go up based on so-called sympathy plays. But sympathy plays might have short-lived spikes because they don’t have a direct catalyst.
- Companies following trends with bad financials. If a company’s trying to ride a current fad but has poor financials, it’s probably not a good choice for a longer position. But it could be promising for short selling.
Important Considerations When Short Selling
Short selling is different from the traditional method of buying and selling stocks, so it’s important to keep these considerations in mind:
- Not all brokers offer short selling. If you’re interested in short selling, be sure to check if it’s a service your broker provides.
- There’s no guarantee that shares will be available. Even if your broker does offer short selling, that’s no guarantee that there will always be shares available to borrow.
- Losses can be unlimited. Many consider short selling dangerous — while there’s a potential to profit, there’s also the potential to lose. Even if the stock price goes up instead of down, you need to return the shares to your broker. So you’re still obligated to buy back those shares. That means it’s possible for losses to mount quickly.
- Short selling is a short-term strategy. In general, because of the risk involved with short selling stocks, it’s used as a short-term rather than long-term strategy.
- It’s more common in bear markets. Less optimistic bear markets typically offer more opportunities for short selling.
SwingTrades With Paul Scolardi
I’m Paul Scolardi, an active swing trader and the lead teacher at SwingTrades.
As a trader, I don’t follow the masses. I try to figure out what might happen in the future, so that I can be ahead of the curve rather than chasing trends.
Through the course of my career, I’ve figured out methods of locating hot sectors before they explode by looking for earnings winners, watching sector leaders, and finding hot IPOs.
Curious about my techniques? Consider joining my SwingTrades program.
In the program, my focus is to help my students become self-sufficient traders with a solid understanding of a variety of trading methods. At this point, I’ve taught over 1,400 students from 50 different countries!
Trading requires a lot of hard work and dedication. There will always be risk associated with trading, and it’s always possible to lose your investment.
So remember: trading is always at your own risk.
But you can make more informed trading decisions by learning how the market works. Check out SwingTrades to further your education!
What’s your experience with short selling? Leave a comment and tell me how it went!