10 Short Selling Basics To Know

fallingstock

I’ve locked in profits of nearly $500,000 in the first 3 months months of 2014, but with the overall US stock market turning bearish and speculative stocks hyped by penny stock pumpers like this getting crushed, it’s time we take a step back from being so bullish and remembered you can make money when the stock market drops thanks to short selling.

I HIGHLY encourage you to see which brokers are best for short selling and to watch this study guide on short selling and to watch these 2 GREAT short selling live trades:

…read below for some more basics:

It’s hard for some people to grasp the fact that you can sell something you don’t have, in this case a share of stock

So, I wanted to write a blog post that breaks down short selling into 10 things that you must know if you want to start shorting.

First, the definition of short selling.

According to Investopedia, short selling is “The sale of a security that is not owned by the seller, or that the seller has borrowed. Short selling is motivated by the belief that a security’s price will decline, enabling it to be bought back at a lower price to make a profit. Short selling may be prompted by speculation, or by the desire to hedge the downside risk of a long position in the same security or a related one. Since the risk of loss on a short sale is theoretically infinite, short selling should only be used by experienced traders who are familiar with its risks.”

Second, let’s give an example of short selling. You look at stock XYZ and believe the fair value is $20, while its current market price is $30. This means you believe it should fall by 50% from where it is currently trading. Sure, you could wait for it and then buy it, but why not make money on the other side of the transaction? You can sell the stock and make a 50% profit rather than wait for it to go to where you believe is a reasonable buying price. So, you can borrow 100 shares from your broker, essentially taking out a loan, at the current price of $30 in hopes of it declining in value. If the stock goes up by $5, then you have lost $500, but if it goes down by $5, you have made $500.

Third, your broker can tell you to buy back the shorted shares at any time. This is the worst and scariest thing about short selling. This is referred to as a “buy in.” This usually only happens with stocks that are heavily shorted. It means that a brokerage can close out a short position at any time if the stock is exceedingly hard to borrow and the stock’s lenders are demanding it back. There isn’t anything you can do besides buy back your shares, no matter what the current price is.

Fourth, you should know two metrics involved in short selling. The first is the Short Interest Ratio (SIR). SIR is the ratio of the total number of shares sold short divided by the stock’s average daily trading volume. The second is simply Short Interest. This is the total number of shares sold short as a percentage of the company’s total shares outstanding. When these two metrics are high for a specific company, it may be at risk of a “short squeeze.”

Fifth, let’s define a short squeeze. This is when that company that is heavily shorted moves sharply higher, which then forces more traders to buy back their shares and move the stock even higher. A short squeeze implies that short sellers are being squeezed out of their short positions. This type of event is usually triggered by a positive development or Friday afternoons when people do not want to be short going into the weekend. Investopedia provides this fantastic example:

“Consider a hypothetical biotech company, Medico, that has a drug candidate in advanced clinical trials as a treatment for skin cancer. There is considerable skepticism among investors about whether this drug candidate will actually work, and as a result, 5 million Medico shares have been sold short of its 25 million shares outstanding. Short interest on Medico is therefore 20%, and with daily trading volume averaging 1 million shares, the SIR is 5. The SIR means that it would take 5 days for short sellers to buy back all Medico shares that have been sold short. Assume that because of the huge short interest, Medico had declined from $15 a few months ago to $5 shortly before release of the clinical trial results. When the results are announced, they indicate that Medico’s drug candidate works better than expected as a treatment for skin cancer. Medico’s shares will “gap up” on the news, perhaps to $8 or higher, as speculators buy the stock and short sellers scramble to cover their short positions. A short squeeze in Medico is now on, and can drive it much higher due to massive buying pressure.”

Sixth, know that a lot of people are worried about short selling since stock prices have unlimited upside but limited downside (they can only go to $0). But, when is the last time you saw a stock go to infinity? And if you listen to Tim, you would “cut your losses quickly,” which is one of his cardinal rules and keys to success.

Seventh, remember that you are borrowing money when you short a stock. This is known as margin trading. When short selling, you open a margin account that allows you to borrow money from your brokerage firm. Just as when you go long on margin, it’s easy for losses to get out of hand because you must meet the minimum maintenance requirement. If your account slips below this, you’ll be subject to a margin call, and you’ll be forced to put in more cash or liquidate your position.

Eighth, you may be right, but at the wrong time. I had a friend that shorted BlackBerry back in February. The stock stayed about unchanged, then went up a bit. Eventually he got sick of letting his money just sit there and closed his position. But in June, the stock began its long tumble of more than 50% from where he had gotten in.

Ninth, because you don’t own the stock you’re short selling, you must pay the lender of the stock any dividends or rights declared while you’re short. Tim never holds long enough to have to worry about this.

Last but not least, know that there are two main reasons to short: speculating and hedging. When you are speculating, you are taking on more risk than if you were hedging. Speculating is just taking one side of the position and hoping that fluctuations in the market will make you profitable based on your research and the way you placed your bet. Hedging is protecting your other positions. For example, lets say a farmer has 100 acres of corn. He’s going to have to sell that corn eventually, so he can short the price of corn right now so then he makes money when the price declines, but technically still makes money when the price goes up since he’ll be able to sell his own corn for more.

I highly recommend both Pennystocking DVD’s and the ShortStocking DVD to learn more.

Posted in Basics, Short Selling, Short Selling Penny Stocks

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  • JayT

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  • cd

    thanks

  • Harry

    Thanks, Tim right after finals I am signing up. I can’t wait to learn all these strategies and more.