Short Selling Tips
Short selling – also referred to simply as ‘shorting’ – is a vital trading tool that every trader should be acquainted with. It provides several benefits to the active trader. First, and most importantly, it significantly increases the number of trading opportunities you will have. If you are only trading to the long side, you are missing out on every stock in decline. This is particularly true when the market is in a bearish phase – if you aren’t shorting, your trading opportunities will be extremely limited.
Short selling will also improve your understanding of the market. Rather than viewing the world solely through the eyes of a long-biased trader, you’ll begin to see and understand the motivations of those on the other side of every trade.
You will also better understand and identify short squeezes, which occur when a stock surges up unexpectedly. Identifying these moves before they occur will keep you out of trouble on your shorts and provide some great long-side momentum trades.
What is short selling?
Before we can dive into our short selling tips, you need to understand what shorting is.
- When you short a stock, you first borrow the shares from your broker and immediately sell them.
- Closing a short trade is called covering and it involves buying those shares back and returning them to your broker.
- If the stock decreased in price from when you shorted it, it costs less to buy the shares back than what you sold them for and you pocket the difference.
- If the stock increased in price, it costs more to buy the shares back than what you originally sold them for. The difference is your loss.
How do you short a stock?
Margin account – When you sell a stock, it takes up to three days for it to fully clear. During that period of time, your capital is tied up. With a margin account, the broker allows you to trade as if the capital was available again immediately. A margin account is required for short selling (as well as day trading in general)
Shares available to short – If your broker doesn’t have shares available to borrow, you cannot short the stock. Some brokers have an extensive list of stocks available to borrow, while others are very limited. Some stocks are impossible, or next to impossible to short, such as IPOs.
Alternative Uptick Rule – This SEC rule prohibits traders from shorting a stock that has dropped more than 10% in one trading day. The purpose is to stop flash crashes from occurring.
How do you manage risk when short selling?
Here are short selling tips for risk management:
- Clearly define your stop loss level before you enter the trade. Once you are in the trade, honor that stop
- Know your setup and use that knowledge to establish points to scale out when profitable
- Choose a position size that doesn’t place excessive risk on your overall account size, but is large enough for you to profit after commissions and slippage
Keep in mind that your losses are (theoretically) limitless on a short trade. With a long trade, your stock can down to zero and you lose the entirety of your initial investment. With a short trade, because you are responsible for purchasing the stock again regardless of the price, you can lose many multiples of your initial investment. For example, if you short a stock at $10 and it jumps to $100, you will lose 10x as much money as you originally invested. So, an initial position of $10,000 would lead to a $100,000 loss.
For more short selling tips, including one of my favorite shorting strategies, check out this video!
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