In most cases, when people decide to invest, for example by buying a stock, they hope the market tends to rise. By buying a stock at a lower price than the selling price, they will be able to make a profit. This investment strategy is called "going long" in technical jargon. Selling a stock short or "going short" means doing exactly the opposite. Instead of assuming that the stock price tends to rise in the future, people who sell short assume that the value of their investment is reduce over time. How to implement a short selling strategy? How to make a profit? Continue reading the article to find out.
Steps
Part 1 of 4: Knowing the Basics
Step 1. Learn the technical terms
When it comes to short selling a security or a financial asset, you need to know the meaning of three specific terminologies: going short, hedging a position, margin.
- Going short is the operation that involves selling a stock without owning it. When you go short on a stock, you sell a stock at a certain price by borrowing it from your broker, who in this case acts as your guarantor. Put simply, you are assuming, based on your analysis, that you are able to buy back the sold stock at a lower price, resulting in a profit.
- Hedging a position means closing your sell transaction by buying the same stock. Since your broker has only temporarily lent you the shares you sold, you are forced to buy enough shares to cover the loan to close your position.
- Margin is the means by which you can execute your financial operations. When you buy on margin, in practice, you borrow from your broker the necessary funds to buy or sell shares which will then be used as collateral for the loan itself.
Step 2. Talk to your financial advisor
If you use the services of this professional, consult them to discuss the options and investment tools suitable for your situation. Short selling is a very aggressive strategy and consequently subject to a high risk. Depending on your financial situation and the investment goals you have set for yourself, short selling may or may not be a good strategy.
A financial advisor can determine when it is correct to sell short. In order to reduce the risk to which you expose yourself, it is also able to recommend different tools that can be combined with this strategy
Step 3. Consider the benefits
If the analysis is correct, short selling can generate excellent profits. Consider the following example: You want to short sell 100 shares of XYZ company. The present value of this stock is € 20 per unit. Contact a broker and open an account with a minimum deposit of € 2,000 as margin. Then ask the broker who acts as guarantor for the short sale of 100 shares of the company XYZ (the broker will "lend" you the shares present in his portfolio or in the portfolio of one of his clients). Following the transaction, the broker will credit your account with € 2,000.
- After opening your short position, you wait for the share price to drop. At this point the company XYZ releases the report relating to the profits for the third quarter, which are very disastrous. The direct consequence is that the share price drops to € 15. You then buy back 100 shares of XYZ company at a price of € 15 to "hedge" your initial position. You now own 100 real shares that you can return to the broker, who acted as guarantor to open your position. This process is called "hedging" a short position.
- Your profit comes from the difference between the price at which you sold the first shares and the price at which you bought them back to "hedge" your position. In our example, you sold XYZ shares for $ 2,000 and bought them back for $ 1,500. Your profit is then € 500. The earnings will be debited from your account bringing the total balance to € 2,500.
Step 4. Assess the risk
Selling short is much more risky than buying (in technical jargon "going long"). When you buy a stock, you are assuming a scenario where the price of the purchased asset rises. Suppose you buy 100 shares of the JKL company at a price of € 5 per share. In this case, the maximum materializable loss is 100% of your investment, or € 500. On the other hand, your profit is virtually infinite because there are no limits to the growth of the value of the stock you have bought. This means that there is a limit to total losses, but not to gains.
- When you sell short, the exact opposite is true. The earnings you can make have a limit dictated by how much the shares can depreciate, but being able to reach zero at most. On the other hand, you will lose money in proportion to the potential rise in the value of the stock and, as seen above, the achievable price is potentially infinite.
- For example, let us again take the case of the XYZ company seen in the previous passages. Let's assume that we borrow 100 shares of XYZ from the broker for € 20 each and then sell them immediately as we did before. The proceeds from the sale (€ 2,000) will be debited by the broker from your account. Your initial € 2,000 account will rise to € 4,000 after the sale. We are therefore waiting for the share price to fall so that we can "hedge" our position.
- Unfortunately, the share price of the XYZ company does not go down. On the contrary, the value of the shares jumps upwards to reach € 30. Since the market is wrong to you, you decide to limit your losses and close your bearish position, then buy 100 shares at the price of € 30 each. By doing this you can return the shares to the broker and close your position. Since to "cover" your investment you have to pay € 3,000, having earned 2,000 from the initial sale, you materialize a net loss of € 1,000 effectively halving your initial account balance.
Part 2 of 4: Consider the Available Options
Step 1. Run an analysis of your investments
Selling short, as well as going long, is an investment strategy. Check the current market trend carefully and find out which companies or stocks could potentially depreciate in the near future. Don't start your analysis with the goal of going short on a stock; choose to act only when all your data indicates that doing so is a good strategy.
- Equities: When analyzing stock market fundamentals, pay special attention to the expectations for future earnings of listed companies. This is the most important aspect, which has a major impact on the determination of the share price. While this figure is impossible to predict exactly, future earnings can be estimated with an acceptable approximation, based on the appropriate information.
- Stocks can be overvalued. This effect is very common when there are market phases that are called "speculative bubbles" or when a stock is bought en masse on the wave of enthusiastic news about the future of the company. Let's take an example: ABC company has discovered a new drug capable of treating cancer. Investors, enthusiastic about the news, begin to buy the shares of the company pushing its price upwards and taking it from € 10 to € 40 per share in a single day. Although the company's prospects are good, many obstacles still remain before the drug can be successful (the test period, competition, etc.). Those wise investors who take all of these factors into consideration might assume that ABC company shares are currently overvalued, which would lead to a sudden drop in price. Stocks of this type, overvalued, are a great candidate to run a short sale.
- Bonds: Since bonds are a full-fledged financial security, they can be sold short. If you decide to short a bond, look at its value, which is closely related to the interest rate. When the latter falls, the price of the bond rises; conversely, if the interest rate goes up, the price goes down. An investor who decides to short a bond therefore wants the interest rate to rise and its price to fall.
Step 2. Identify the key market indicators
The best stocks to short sell are those whose value will fall shortly, but whose price has not yet fallen. There are several indicators that can help you identify potential candidates to go short:
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Price / earnings ratio (PE). The PE is calculated by dividing the market price of a share by the profits it has generated in the last 12 months (current PE) or by those expected in the following 12 months (future PE). The PE is an important datum, relative to the whole market or compared with other companies. A high PE value could indicate that the stock in question is overvalued. However, it could also indicate that we are analyzing a healthy, solid company with excellent future prospects.
For example, a company whose shares are worth $ 60 each and earnings equal to $ 5 per share should have a PE of 12 (60 ÷ 5 = 12)
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Relative Strength Index (RSI). The RSI oscillator indicates whether a stock, in a given period of time (usually 14 days), has been mostly bought or sold. The RSI is obtained through a complex calculation, simplifying it is represented by the ratio of the number of days of the time interval taken into consideration in which the closing price of the stock in question is higher than that of the previous day and the number of days in which the closing price of the security is lower than that of the previous day. The range of values that the RSI can take varies between 0 and 100.
In general terms, when the value of the RSI is around 70, in the long run, the stock could have a strong increase in the price. However, it could be speculation and not sustainable and linear growth. In technical jargon it is said that the stock in question is "overbought" and therefore a price drop may be imminent
- Both the EP and the RSI, when examined alone, are unable to provide certain and sufficient information. So be very careful and evaluate multiple factors at the same time before deciding to sell a stock short. Remember that none of the existing indicators constitute certain and irrefutable proof for deciding to enter a position by buying or selling an asset.
Step 3. Before shorting a financial security, check its "Short Interest"
This is the percentage of bearish positions relative to the total number of shares of a specific stock available on the market. For example, a stock consisting of a total of 10 million shares, of which 1.5 million are sold, shows a "Short Interest" equal to 15%. The "Short Interest" lets you know how many investors are speculating that the stock may lose value in the short term. This data is in the public domain and is published in financial newspapers, including for example "Il Sole 24 Ore".
- A high "Short Interest" indicates that investors believe that the stock or bond in question may lose value. Perform an in-depth analysis to identify other factors confirming the real plausibility of the hypothesized scenario.
- On the other hand, a high number of short positions could contribute to increasing the volatility of the security under consideration. This occurs when many investors hedge their short positions in a short amount of time, resulting in a rise in the share price. These large market movements are often used by other investors to generate a profit.
- Evaluate the data "days to cover" or "Short ratio". This is the number of days it takes to cover all existing short positions on the stock, based on the volume of shares traded daily. For example, if the "Short Interest" of a given stock is equal to 20 million shares, and the average daily volume traded is equal to 10 million shares, it will take 2 days to cover all the short positions currently open. Investors typically prefer stocks with a low "short ratio".
Step 4. Evaluate the liquidity of the market
Never short-sell stocks with little liquidity. High liquidity indicates a large availability of tradable shares and a large trading volume. If the stock in question has low liquidity, you may not be able to close your positions fast enough to make a profit.
- Stocks with low liquidity expose you to the risk of having to close your position early. If the owner of the shares that have been loaned to you to short-sell (often your broker) decides to sell them, you will be forced to replace them. You can do this by finding another broker willing to offer you their shares or by buying them directly from the market. If the stock is not liquid enough, being able to locate the stocks you need could be very difficult, forcing you to close your positions.
- Be careful because the hedging process of short positions generates a temporary upward movement in the stock price. This is a direct, unintended consequence of short selling. For example, when you short a stock, as a result, its price will tend to fall. To hedge your position, you will have to buy the same number of shares, which will have the opposite effect, ie a rise in the price. If a large number of investors were to hedge their short positions on a particular stock at the same time, the share price could rise significantly. This effect is commonly referred to as "short squeeze".
Step 5. Be patient
Investors who prefer bearish scenarios usually enter and exit the market very quickly. They may decide to make an investment only when the opportunity to make a profit presents itself. So be patient and don't "chase" profits, just wait for the right opportunity to act.
Thanks to the numerous online brokers who offer their services at cheap rates, and to unlimited access to financial information, "day trading" has become a very popular activity. However, it can be a very risky strategy, especially if executed without due experience in the markets. Proceed in small steps and with caution
Part 3 of 4: Opening and Closing Short Positions
Step 1. Find a reliable and safe broker
If you don't have an account with a broker yet, you need to open one. The availability of brokers is very wide, so it can be difficult to find the right one for your investments. Basically, financial intermediaries are divided into two groups: those who offer a complete service and those who only perform the role of financial intermediaries.
- In the first case we are talking about market operators who welcome customers with a large number of financial services and advice on how to invest their money. Often these types of intermediaries offer customized investments based on the client's situation. These brokers operate on commission, i.e. they get their profits from the number of trades performed. Normally the commission percentage of these brokers is higher than that of the brokers belonging to the second type.
- In the second case we are talking about brokers who only perform the role of financial intermediaries, without offering additional services, such as financial advice for your investments or the customization of their products according to your needs. They usually simply carry out the financial transactions you indicate. Since their job is limited to acting as an intermediary with the actual market, the commissions they charge are much lower. As a rule, traders of this type do not get their profits from the investment fees they recommend, but they do receive a salary.
- Check if in the country where you live there is an authority or an association that regulates this type of activity and that can offer you a complete list of brokers and related services offered as well as useful information, for example the curriculum vitae, the number license and any past problems with clients or financial institutions.
Step 2. Evaluate several brokers
Once you have identified a small number of brokers who can accommodate your requests, meet them individually so you can talk to them and ask any questions you want. This process will help you figure out which one will best suit your needs. Here are some useful questions:
- How broker operators are paid. Do they earn a salary or do they work on commission? Do they get additional rewards from the company they work for to suggest investing in its products? Do they receive rewards from other companies for their advice? Is the percentage of their commissions negotiable?
- Commissions. For example, different brokers charge higher commissions for transactions involving a quantity of shares greater than 500 or 1,000. Some types of investments may also have different commission levels. Before making a commitment, you need to know perfectly what awaits you.
- What kind of advice is offered to you. Most brokers can offer a wide range of financial analysis, research and tools that can help you in your investments. Some may offer you access to information from financial companies such as Standard & Poor's. Others provide you with sophisticated financial software that allows you to keep track of market trends. Find out what services and level of advice will be made available to you.
Step 3. Open an account with a brokerage firm
The procedure for opening an account with a broker is very simple and quick. Your account will be used by the broker as collateral for the loan granted to you in allowing you to short sell shares you do not own. Just as with any other loan, from the moment you enter the market, the broker will charge you an interest rate and will use the purchased security (in this case the short sale of shares) as collateral for the loan. Since when you short a stock, you are selling something you do not own, the proceeds from the sale will be temporarily debited to your margin account until you "cover" your position by repurchasing the securities sold.
- The profits from your short sale will be used by the broker as collateral until you cover your position. If the market trend changes, you may lose some or all of your earnings. In order to maintain the integrity of your assets, in certain circumstances, you may be forced to replace the shares or funds relating to open positions.
- In the case of investments that take advantage of financial leverage, in which there is therefore a margin account, the term equity means the difference in the present value of the securities relating to your open positions and the amount lent to you by the broker in order to perform the operation.
- In order to open an account with a broker, you will need to sign a contract explaining all the conditions required for using the margin, including details of the interest rates of the open trades, the conditions and responsibilities associated with the operation. with a margin account. It will also show you how the broker will use the traded securities as collateral.
- Before signing it, read the contract carefully. If you have any questions, ask your broker and persist until everything is clear to you.
- Most brokers require a minimum deposit of € 2,000. Your initial equity will be used by the broker as a "minimum margin". Other brokers may require higher initial liquidity instead.
Step 4. Identify the broker's requirements for trading with a margin account
In the United States, the Federal Reserve Board, together with other associations including the New York Stock Exchange, has created special procedures to regulate trading in the financial markets. In addition to these rules, in order to guarantee you the "margin" with which to operate in the market, your broker may ask you to comply with additional specific requirements.
- For example, in the United States, under "Regulation T", short sales can only be made by having a margin equal to 150% of the value of the securities traded, calculated at the time of execution of the transaction. Let's say you shorted 100 shares worth € 40 each. In order to support the operation, you will need to have a liquidity of € 6,000 which will be used as a margin: € 4,000 will derive from the sale of the shares while the other € 2,000 (equal to 50% required by the laws in force in the United States) will correspond to the deposit initial of your account.
- Once you have opened your short position, in order to keep it short without going into a "margin call", the value of your margin account must not fall below 125%. This percentage may vary based on the broker chosen. Many large brokers require 130% or more.
- If the price of the shares sold goes up, the overall loan amount will increase and your account balance will decrease accordingly. If the stock price falls instead (the scenario we hope will happen), your account balance will increase.
- For example, let's say you sold 100 shares for $ 40 each. Your initial margin account balance will be € 6,000. If the share price rises to € 50, you will be forced to increase the liquidity of the account in order to meet the requirements for "margin maintenance". The value of the shares will now become € 5,000 instead of the initial 4,000. If the broker requires a minimum margin of 25%, in order to replenish the initial margin and comply with his request (in the jargon "margin call") you will have to pay another 250 € into the account.
- If you do not replenish your margin by paying more cash, the broker may decide to close your positions by buying 100 shares at the current market price. In order to cover the margin, you may only have a certain amount of time, after which your positions will be liquidated. In any case, the financial intermediary can always request back the shares he has lent you in order to go to the market and hedge your positions, at any time without notifying you.
Step 5. Borrow the stock from the broker
Before you can short sell the stocks you are interested in, you will need to determine if the stock is available. Stock borrowing is a temporary transaction, which may only be valid for a predetermined period of time. In most cases, the lender of the shares (very often the broker) can request their return at any time.
- In this case, you are not the owner of the shares sold. The broker remains the owner of the equity securities lent, and should you be asked to be prepared to "hedge" your positions or return the shares.
- Almost every broker provides an indicator that shows whether certain shares are available to lend. In the absence of actionable shares, you will not be able to market them by entering the position.
- For the entire duration of the transaction, investors who sell short must pay fees to the owner of the shares.
- The greater the difficulty in finding the security in question, the higher the commissions due to be able to carry out the sale.
Step 6. Enter a sales order
To this end, there are several options, sometimes different from broker to broker:
- Market or best sell order (MKT). Some markets have restrictions on short selling. For example, in the United States, "SEC Rule 201" could be applied, designed to "safeguard market stability and preserve investor confidence". This law prohibits short selling of those shares which have lost more than 10% of their value since the previous day's close and which do not meet certain conditions.
- Limit Sell Order (LMT). This type of order is only executed if the stock price reaches a predefined value. In our case, the limit is the minimum price at which you are willing to sell the shares. Unlike a market order, a limit order does not give certainty of execution (if the price is not touched the order is not executed).
- Stop sell order. This type of order turns into a best order as soon as the indicated price is touched. For example, if you think ABC company stock price will decline after hitting $ 15, you can place a sell stop order at $ 14. If the price reaches € 14 your order will be executed immediately.
Step 7. Enter a "Purchase Order"
To close a short (short) sell position, you must use a buy order to "hedge" the stock that has been loaned to you by the broker. To do this you can choose several options:
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Buy order at market or at best (MKT). The execution of this type of order is guaranteed, but the price obviously isn't. In this case, as soon as the order is placed, you will buy back, at market price, the shares necessary to close your position. This type of order is the best choice under the following conditions:
- You need to hedge your short position as quickly as possible.
- You want to materialize a high profit and are worried that the stock price will rise quickly.
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Limit Purchase Order (LMT). This type of order is executed at a price below the current market price. For example, by entering a limit buy order at a price of € 20, the shares in question will be bought when the price touches or falls above € 20.
If the price does not fall sufficiently, limit orders may not be executed
- Stop buy order. It is the most important order type for those investors who like short positions. You can use it to protect your capital from losses or to preserve profits. When the share price reaches or falls beyond the set price, your order is executed immediately or as soon as possible, based on the liquidity of the market, as if it were an order at best (MKT). In this case the execution price is not guaranteed.
- Inexperienced investors should always place a stop order as insurance against possible large losses. For example, assuming that you have sold short the shares of the company ABC at a price of 60 € per share, you should immediately place a buy stop order (also called "stop loss") at the price of 66 €. In this way, if the price were to rise up to € 66, your order would be executed by buying enough shares to "cover" your position and effectively blocking the losses before the price rises again. This procedure limits your losses to a maximum of 10% of your investment.
- If, on the other hand, the price were to drop to € 50 per share, you could cancel your original stop order, placed at € 66, and place a new one at € 55, effectively protecting your profits from a possible rise in the price. This type of order is known as a "trailing stop (TS)".
Part 4 of 4: Knowing the Risks of Short Selling
Step 1. Be prepared to pay interest on your short position while you wait to be able to hedge
Normally you will be able to stay in the market with a short position for as long as you like, but since, in this case, the shares sold were loaned to you by the broker, you will have to pay interest on the loan. The longer your position remains open, the higher the amount of interest you will have to pay. Unfortunately, free money does not exist.
When shares of shares sold short are difficult to find on the market, the interest rate charged is higher. In extreme cases, the interest rate could even exceed 20%
Step 2. Be cautious, some investors may be "called back"
This happens when the owner of the shares being sold demands them back. The reasons for his request could be different, for example an investor could be forced to hedge his positions because the broker "calls" his shares (remember that a stock sold short is not owned by you, you are just "taking it" borrowed"). In the event of a recall, you will be forced to hedge your position regardless of whether it is making a profit or a loss.
- As you are not the owner of the shares you are short selling, you may have to close your positions at any time. Many brokers and banks reserve the right to request the return of their shares or securities at any time, without notice.
- While not a frequent scenario, it's not all that rare. In fact, it can occur when a large number of investors try to open short positions on a particular security at the same time.
Step 3. Note that "margin calling" may force you to take action
As an investor the broker will ask you to maintain a certain level of margin when you are in the market. If you go into "margin call" because your account balance has fallen below a certain minimum value, you will be forced to deposit new liquidity to restore the initial margin or to close open positions. If you are unable to restore the minimum margin as requested by the broker, you may need to hedge your positions earlier than expected.
- In the United States, the Federal Reserve Board requires a margin of 150% of the value of the shares in question to carry out short sales. Many brokers may have additional requirements. In this case, if you want to short 100 shares worth € 20 each, your account should have at least € 2000 liquidity as margin. You will also have to pay an additional amount equal to 50% of the value of the shares you wish to sell, in our case equal to € 1000 in order to bring the margin to € 3000 total.
- If the price of the shares sold short goes up to € 30, you will need to pay more cash into your account to meet the required margin. Since the value of the shares sold has now risen to € 3,000, you need to cover the difference. If your broker requires a margin of 25%, to avoid going into "margin call", you have to deposit another 750 €.
Step 4. Note that decisions made by companies can increase the risk of your operations
In addition to the already high risk of short selling, the choices made by the company you invested in could affect the profits and losses generated by your trades. In fact, you will have to pay the dividends relating to the shares sold and cover the additional shares deriving from a split.
- For example, publicly traded companies often pay dividends to their shareholders. If this is the case with the company whose shares you have short sold, you will have to pay the sum corresponding to the dividends generated by your open positions.
- Consider this example: You short 100 shares of company XYZ. While you wait for the price to drop in order to cover your operations, the company in question decides to pay a dividend to its shareholders equal to 10 cents per share. This means that you have contracted a debt of € 10. In this example the loss may seem insignificant, but relative to a large number of stocks or larger dividends, it is easy to realize that the losses can become very large.
- Should the company decide to split its shares, you will become responsible for a greater number of shares. Normally the split is performed with a ratio of 2 to 1. In this scenario, the XYZ company could split its shares, whose current value is € 20, into shares with a value of € 10, thus doubling the number. Having sold 100 shares of € 20 short, after the split, you will have 200 shares of € 10. Materially, a split does not change the positions of investors; However, note that in order to hedge your positions, you will now need to buy back 200 shares instead of 100.
Step 5. Make sure the weather is not against you
Investors who buy stocks often hold their investments for significant periods of time, waiting for the right time to sell. Some investors hold their shares for life. Whoever sells short works against the clock, often having to sell and then cover the sale very quickly. Since he borrows the position from his broker, the short seller operates with the time allowed by the broker.
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If you decide to do a short sale, you need to be reasonably confident that the stock price will drop rapidly. Give yourself a time limit within which to decide what to do. If the share price has not fallen after your set limit expires, re-evaluate your position:
- How much are you paying in terms of interest?
- How much are your losses?
- Is the analysis that prompted you to enter the position thinking that the stock price might go down still valid?
Advice
- Be cautious about using this financial tool, at least until you have developed a reliable system for selecting the securities to sell.
- Avoid short selling shares of companies already hit by a large mass sale, and with a value of the "Days to Cover" indicator (indicates the number of days required to cover all existing short positions based on the volume of shares traded daily) very high.
- Always keep your account margin high, to avoid exposing yourself to what is called a "margin call"; if necessary, transfer other liquidity to your account. If your margin decreases it is evident that your position is contrary to the current performance of the chosen stock. Close your positions and get ready for the next trade.
- When you open short positions ("short"), always closely monitor the market trend. If for any reason you cannot control your trades constantly, close all your short positions.
- Remember that short sales are transactions that, in the long run, generate high costs that can affect your possible profits.
- Pay attention to sellers' interest in the shares you intend to "short". When the number of investors wanting to sell short is too high, the stock can be placed on a list of stocks that cannot be sold, called "hard-to-borrow" (for internal use by banks and brokers). In this case you will have to pay an additional commission to be able to sell this type of shares.
Warnings
- If for any reason the broker, or the bank that acts as guarantor for the short sale of the shares (i.e. the entity that lent you the shares to execute the sale), requests that you return them, you will need to find someone else. willing to act as guarantor or you will be forced to close your positions.
- Be careful when you decide to open a short position on a stock with a high "Short interest", because if all other investors decide to hedge their positions you could materialize a loss due to the consequent rise in the price.
