You may not think making money is possible when stock prices are trending down, but, it is… with the acceptance of certain risks!
One method with the potential to turn a profit when buying stocks is the short sell.
One of the common strategies for capitalizing on stocks in a downward trend is short selling. This process involves selling stocks which were “borrowed” at the current market rate; the deal is not finalized until you purchase the borrowed stock, typically on some date in the future. In other words, you profit from a short sell if the price of the borrowed stock drops some time between entering the agreement and delivering the stock. However, if the stock increases, you walk away with a loss. Investors should note short sells can apply to other types of investments, such as REITs and ETFs, though, mutual funds are not included.
Investors interested in short selling stock can employ a short-term strategy; however, knowing the risks inherent in this strategy is key.
Short selling is ideal for investors interested in pursuing short-term stock opportunities or other applicable investments whose price is expected to decline.
This technique is not without risk and the biggest is the possibility of the stock’s value increasing between entering and closing the deal, leading to a loss. Theoretically, the potential for a stock’s price appreciation is unlimited, which also means its potential for loss in this short term situation is also without limit.
Another inherent risk is the role of margin in shorting a stock. If the security price of a shorted stock increases, the short seller may be held accountable to a margin call. In the event of a margin call, the short seller is required to supplement the balance of an original margin by making additional deposits in the account.
One limitation to short selling downward-trending stocks is the SEC reserves the right in certain situations to place restrictions on who may short sell, what stocks are permissible, and how short selling can take place. For example, the SEC may place ad hoc restrictions on short sells. This happened during the financial crisis of 2008 in an effort to stem further panic; the SEC placed a temporary restriction on naked short selling of stocks whose share prices were the focus of rapid decline, such as banks. Naked short sells involve shorting stocks you do not actually own.
Another potential restriction imposed in short selling is the uptick rule. The rule exists to prevent driving a dropping stock price further down (i.e., more than a 10% drop in one day of trading). If traders are going to engage in short sells, they need to be aware of these limitations and how they might impact their investment strategy.
To get an idea of how a short trade works in short selling stocks, take a look at a hypothetical scenario with a company called, for this example, ABC:
Assume ABC stocks trade at $50 per share on May 1. ABC may be a candidate for a short sell if a trader does not expect the company’s stock to perform well in the coming several weeks. So, the trader would place an order for a short sell in his or her brokerage account, in order to capitalize on this prediction.
The trader can option, when filling an order, to set the stock’s market price at an entry point for short selling. While the stock is still trading at $50, assume the trader placed a market order for short selling 100 shares. Should the stock drop to $40 and the order filled at the market price, the trader would come away with a $1,000 profit (i.e., 100 shares times a $10 gain per share), including less interest, commissions, and additional charges.
On the flip side, say the stock increased to $60 per share, with the trader choosing to close before further losses were incurred. In this case, the trader would come away with a $1,000 loss, with additional interest, commissions and charges. With the potential for stocks to increase indefinitely, the potential for short sell losses is also indefinite; therefore, utilizing limit orders may help with risk management.
Investors must recognize securities with the potential to become overvalued in stocks to watch, identify when the decline may occur, and at what price.
Timing is key in short selling.
Opportunities for short selling arise from the overvaluation of assets. Think back to the existence of the housing bubble prior to the great financial crisis. The prices of houses had become so inflated that, when the bubble finally burst, a sharp correction followed.
In some cases, the duration of an asset’s overvaluation can outlast a short seller’s solvency. For example, a trader may anticipate a certain sector encountering strong headwinds industry-wide in six months, thus designating short-sale candidates from among those stocks. The reality, however, is it may take time for the stock prices of those designated companies to reflect the industry problems, requiring the trader to wait before establishing a short position.
The length of time a trader may remain in a short position can vary greatly (from one day to several weeks) based on the trader’s strategy and a security’s performance. Considering the particularly time-sensitive nature of short selling, including the potential for more tax treatment impact, it is a strategy requiring attention and experience.
One can adopt added measures of protection to a short sale, even if one frequents the market, by setting trailing stops and placing limit orders. These may help limit or reduce risk exposure and could even automatically lock profits once they reach a certain level.
Short selling stocks may be a useful tool to add to the repertoire of experienced traders.
The strategy behind shorting is identification of an industry or sector’s winners and losers. Employing a short strategy may also help hedge longer, pre-existing positions. For instance, suppose an investor in the hypothetical ABC company expects shares to weaken in the coming few months, but, is not interested in selling the stock. One way the investor could approach the situation is to short ABC when he or she predicts the weakness; when the stock is anticipated to strengthen, the investor could then close the position.
The process of shorting a stock is relatively simple, yet, this is not a strategy for inexperienced traders. If you’re new to trading stocks, seek the guidance of knowledgeable, practiced investors who know the potential implications of short selling stocks.
