Why You Don’t Need to Fear Short Selling

short selling

Short Selling

As I outlined in this MUST WATCH video lesson, short sellers are longs best friends lately, spiking up stocks far above what they’re worth! I thank them repeatedly for enriching several of my top trading challenge students and myself thanks to their narrow-mindedness and groupthink 🙂

If you’re fairly new to trading, the notion of short selling may seem particularly daunting, or even downright scary. But short-selling is not something to be feared, it’s a tool to use to be learned in order to round out your trading activities and take advantage of situations, just like longs have done nicely the past few days on BLNK and HEAR.

So why does short selling seem SO daunting?

Well, like most seemingly daunting tasks, short selling is not daunting in itself, it’s more the idea of it that’s been made scary. People have it stuck in their head that short selling is something to avoid. Too complicated, too risky. Too labor-intensive. People have created this mental barrier, shielding themselves from something that could prove to be quite lucrative, simply because they don’t know enough about it, and they don’t know where to start. And once someone has made their mind up about something, it can be difficult to change it.

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Add to that the multitude of perhaps well-intentioned internet posts that spew gloom and doom with regards to short selling—“Why you should never short-sell stocks” “How to Short Sell Stocks and Why You Shouldn’t”—and you have a perfect storm that has effectively demonized this trading strategy.

But if used prudently, short-selling can indeed prove useful, particularly in a bear market and when betting against penny stock scams like these.

So, where to begin? If you have already decided short-selling is not for you, I urge you to at least entertain the notion that there might be something in this post that you can use. You might be pleasantly surprised, and if nothing else, it will broaden your understanding of trading and the market in general—and education is always useful and never wasted.

First, I believe there is this misconception that everyone knows what short selling is. Some people are just afraid they’re the only ones that don’t know what it is. In their mind, this means that it’s not that topic that is difficult to understand, it’s that they themselves are incapable of understanding it. That’s just not true. Many traders don’t fully understand what short-selling is. This isn’t helped by the fact that  the name “short-selling” isn’t terribly intuitive.

I’ve read the various web definitions on what short-selling is, and I understand why this topic is widely misunderstood. If you’re fairly new to trading, the terms used to describe short-selling don’t always make a whole lot of sense, either. So how would I describe short-selling to a non-trader? Let’s start out with a super basic, not entirely thorough, analogy—just as a starting point.

We’ll start with a normal trade. Kim wants to buy 5 marbles. The going rate for marbles is $2 each, so she pays Sarah $10 for her 5 marbles. A day later, marbles are selling for $3 each. Now Kim sells her five marbles to Jack for $15—a profit of $5. That’s an easy analogy for a regular purchase.

Now let’s look at a short-sell (of marbles): Kim is thinking the price of marbles is going to plummet, because marble demand is expected to decrease tomorrow. The going rate is $2 each today, but she thinks that by tomorrow, marbles will be $1 or less. Kim knows there is still a way to profit from the future price fall: she can short it. Kim goes to the bank and tells the bank of her plan. The bank knows a customer—Mike—who has marbles. The bank borrows Mike’s five marbles and sells the marbles on the market for $10—for Kim. The bank puts the $10 from the sale of the marbles in Kim’s bank account. The next day, marble prices halve. Kim calls the bank to “cover” her position—meaning she will now buy five marbles from the market (from her account of $10) at today’s price of $1 each, or $5. The five marbles are then returned to its rightful owner, Mike.

In a tiny nutshell, short-selling involves borrowing a stock and selling it, and then buying the stock (hopefully at a lower price) and returning it to the owner—pocketing the difference. That’s borrow it, sell it, buy it, return it.

So…why is that looked upon with such trepidation?

#1 Endless Risk. Unlike regular trading, short-selling comes with infinite risk. Yep: infinite. In theory, the price of marbles, after you borrowed them and sold what you didn’t own, could go up—and up, and up, even to infinity. You could be left covering an infinite gap between what you sold it for and whatever price it reaches. And the bank (your broker) could demand that you cover that stock whenever it chooses.

All trading comes with risk, but with long positions, the lowest a price can go is zero, and since you bought it at a specific amount, the largest amount you can lose is the amount you paid for it. Not that that’s a good thing. Betting $1 million on a stock and having it plummet to $0 is still horrific and risky. So I’m not sure the notion that short-selling comes with some untenable risk is entirely fair. But, mathematically speaking, the risk is endless—and can even extend beyond what you have. You could lose way more money than you have—in theory. At least with long positions, the complete risk is known up front. Even when faced with losing everything, which is possible in any long position, there is some comfort in knowing the absolute maximum that you could lose. (Which is why you MUST follow rule #1 here on all short-sells no matter how much you hate the company/stock!

#2 Limited Returns. Normal stock trading comes with the possibility of infinite returns, and limited risk: if you paid $5 for a stock, the most you can lose is $5 if the price falls to $0. In long positions, your profits are limitless—the price could theoretically go up and up into infinity, meaning that your profit-making opportunities are—at least in theory—limitless. But in short selling, the inverse is true. The most you can make from shorting a stock is how much you put into it (or rather, how much you borrowed). So for a $5 stock, the most you could possible make is $5, and that’s a best-case scenario that would only happen if the stock becomes completely worthless and falls to $0. Because the risk is endless and the rewards are capped at a specific amount, traders don’t always see short-selling as a mouthwatering prospect, especially to the newer investor who is often looking for a small number of huge returns, rather than a large number of small gains over time.

#3 Not every stock can be shorted. “No shares available.” Is a common response to an inquiry to short a certain stock. In the marble example above, notice that the bank borrowed Mike’s marbles. Oddly enough, Mike is blissfully unaware of this five-finger lifting that would see his shares returned to him at a later date. Mike’s account is never affected—just the actual marbles removed—so it doesn’t actually show up on his statement. But the only shares available for borrowing are held in margin accounts. Stock held in cash-only accounts are not available for borrowing, and therefore and not available to short sellers. Also, penny stocks (stocks under $5) cannot always be shorted either, and will vary depending on your broker. Sometimes, you will get this “no shares available” message even when it is possible to short the stock in question. You will simply need to call your broker and enquire if any shares are available to short, and they will try to find it for you. Also note that some brokers will tell you—erroneously—that stocks under $5 cannot be shorted due to SEC rules. This is not so. You can read more about this here: Can You Short Sell Stocks Under $5? The takeaway here is that the stock you are looking to short will not always be available by your broker. You will have more opportunities if you work with multiple brokers.

#4 Covering may not be as easy as you think. Liquidity may be low, meaning that when you want to cover your position, you may not be able to find any shares to buy when you want to—let alone at the price you want.  Also, just because marbles were $2 each today, doesn’t mean that tomorrow—or whatever day—they’ll be $3 before they hit $5, or $10. Tomorrow, they could be $20, and have skipped all the increments in between. You may not be able to close out your position along the way, because there may not be an “along the way”. Prices do not necessarily hit every (or any) point in between.

But it’s not all bad.

Saving grace in a bear market. Bear markets are rough; it’s hard to find stocks that are poised to run. In a bear market, it’s much easier to find stocks that will soon be on their way down, and short-selling opens up a whole other avenue of making money that would otherwise not be available to you. When you only know how to trade long, you are only able to benefit from half of the trading tools.

Shorting stocks opens up a world of opportunity for the savvy investor, but it’s important to fully understand how it works, and the strategies involved, before jumping in with both feet.

Let me know if you’re ready to short sell, or at least learn how the other side thinks so you can take advantage of short sellers as outlined here!