You’re tired of the usual investments: bank CDs, bonds, and the mutual funds inside your 401(k). What you really want, and need, is an “edge.” While most investors who invest in stocks “go long,” you’ve decided to short-sell. There’s just one problem: what the heck is short selling and how do you do it without wrecking your investment portfolio?
What Is Short Selling?
Usually when you buy stocks, you load up on your favorite picks and just hold onto them. You don’t worry about getting rid of them. You worry about profiting from them. Most brokers will tell you to invest for the long-term, unless you talk to the swing-trade folks. But, in most cases, the advice you’ll hear is “go long.”
“Going long” means you buy a stock with the intention of holding it forever, or at least for more than one year. It’s a sound investment strategy, but it’s not always the most profitable. Let’s say you’re looking at a stock that’s doing well right now, but you think it’s about to crash.
You don’t want to buy it, but you’d sell it if you actually owned it. Here’s where short-selling comes into play. Short-selling is a process whereby you borrow stock from a brokerage firm and sell it to another buyer. At some point, the borrowed shares must be bought back by you and returned to the lender. The proceeds from the sale go to your investment account.
So, for example, let’s assume you borrowed 1,000 shares of stock in a particular company, and then subsequently sold it for $20 per share. That’s a sale price of $20,000 – you owe the brokerage firm $20,000 because remember you borrowed those shares which are worth $20,000 right now.
You hope that the share price falls below $20 per share so you can recoup the money. If it does, you profit. Continuing our example, let’s say the share price falls to $10 per share. Now the stock is only worth $10,000 – cool. You only owe the brokerage $10,000 now.
Wait. What? Yes, that’s right. You only owe the brokerage $10,000 now. Why? Because you borrowed 1,000 shares of stock, not $20,000 of cash. So, you buy back the stock at $10,000 and return the 1,000 shares to the brokerage.
Do you see what just happened here? You sold the shares for $20,000, so there was $20,000 in cash sitting in your investment account. You held onto this money and waited until the stock fell to $10 per share and then bought back the same 1,000 shares. This time around, however, you only had to spend $10,000, leaving you with $10,000 left in your investment account. That money is yours to keep.
What About “Days To Cover”?
There are a few things that can foul up your short selling. One of those is the short squeeze. Let’s say you borrowed the same 1,000 shares as outlined in the above example. However, the days to cover shows that it can take 30 days to cover the short. That’s a long time. It means that, to cover your short sales (i.e. buy back the shares you borrowed), it might take up to 30 days. A lot can happen within 30 days.
In fact, a lot typically does happen in 30 days. When you short a stock, you want the ability to buy it back rather quickly – say inside of 7 days. That way, other traders can’t start buying up the shares, causing the stock’s price to momentarily rise. Remember, you profit when the stock’s price falls. Rising prices means you’re losing money.
Longer days to cover also indicate that most of the traders in the market have already sold the stock short. That, in turn, means that a further decline in the stock is unlikely.
Having A Plan
You always need a plan of attack. One of the first things you’ll need is a good brokerage firm. Companies like BrokerStance review and rate brokers based on transaction or execution speed, reliability, and cost. But you need to have a few other things in place as well.
Technical Plan – a technical plan refers to understanding the technicals of a stock you want to trade. Technical analysts use historical data as predictive models for investing. You’ll want to work with a broker that has access to, or generates its own, modeling. That way, you can spot trends and see where – generally – your stock is headed.
Picking Your Entry Point – a good entry can mean the difference between profit and loss. A lot of entry points are calculated according to principles of value investing, but they can also be calculated based on technical data.
Using Indexing Funds – if picking individual stocks sounds scary, you can always invest in mutual funds that short a basket of stocks. Most of the work is done for you. You just have to pick a good manager that doesn’t kill you with fund fees.
Using Stops – at some point, you’ll want to cash out and make a profit. Use automated stops to sell your stock at a predetermined price, regardless of whether you’re in front of your computer or not.
Jarryd Harden enjoys sharing trading strategies online. His articles mainly appear on onvestment blogs.