This is a GREAT guest post from a trading challenge student who has fallen in love with short selling…rightfully so as these free video lessons teach:
If you have never shorted a stock before, or if you are just getting started trading stocks, you need to read these facts about short selling before you make any more trades. So many people are not aware of these facts, but Tim’s students know them and are profitable because of that. These are all very important, so take notes!
Download the key points of this post as PDF.
When you buy a stock, the worst that can happen is that the stock goes to $0 and you lose the money you invested in it. When you short sell a company, you can lose much more. Say you short sell XYZ at $10 and then it goes to $30, you have lost more than what you put into it. This is much different from when you buy a stock at $10 and it goes to $0. A stock will never be worth less than $0.
It can be very difficult to find shares to short of a specific stock. Many times, you have to reserve the shares or short it a little early since the shares most likely won’t be available when you actually do want to execute a short sell.
Be careful to pick stocks that have enough liquidity. This goes for both buying and shorting stocks. The lower the liquidity, the harder it is to get in or out of a position. Remember, when you buy, someone has to sell and vice versa.
You will most likely need to have a margin account in order to short stocks, which means you may have to put up slightly more capital than if you were just planning on buying stocks. The amount of money you need to open an account will vary based on what broker you use.
You may experience a trader’s nightmare; a margin call. This means that you need to put more money into your account, also meaning you have fairly large losses in your account. When you use margin, you are basically taking out a loan from your broker. If you do not put up more money into your account, the trade will be automatically closed and you will no longer hold that position.
The dreaded short squeeze. This is another short sellers’ nightmare. If there are a lot of buyers that come in all at once, for whatever reason, the stop will shoot up in price. This could happen when a stock has a large number of shares shorted and good news is released. People will be rushing for the exits and others will be trying to buy up the shares like crazy. This is also typical on Friday afternoons, as many people don’t like to be long over the weekend. As a short seller, you’ll inevitably experience this at some point. Just follow Tim’s rule of cutting your losses quickly and you will be fine. Most people just don’t follow that rule since they are ignorant suckers that don’t want to take the time to learn what they are doing before entering the trade.
Please make sure you know how to exit your position before you enter it in the first place. When you short a stock, you will need to “buy to cover” when you want to exit the trade. Many people make the rookie mistake of filling out the trade order form incorrectly. Please don’t be one of those people.
Tim never uses stop losses, but that is also because he rarely trades if he isn’t going to be able to watch the trade closely. If you plan to leave your computer for a fair amount of time after you enter a short position, I highly recommend using a stop loss. If you don’t, you risk the stock rising rapidly and losing far more money than you ever thought you would. A stop loss will automatically exit you from the position if the stock reaches a certain level. Though do keep in mind that stop losses are not fool-proof.
Have a plan before you execute a short sell. How many times have Tim or I blogged about having a PLAN before entering any sort of trade? Countless; so it must be important, right? This is one of the keys to becoming a profitable trader. I really have no idea how some people think they will earn a lot of money trading stocks without having a plan before they enter their trades. The plan should remind you why you shorted the stock, what your target price for the stock is, and at what price you should exit your position. Also, do not let your emotions get in the way of sticking to the plan.
This doesn’t apply to all stocks, especially the penny stocks and micro-cap stocks that Tim specializes in, but beware of dividends if you are a short seller.
If you are short a stock at the market close the day before the so called “ex dividend date,” you will owe the dividend.
This means that it will be deducted from your trading account and paid to the person who actually owns the shares.
For example, say you own 100 shares of company XYZ, and then company XYZ declares a dividend of 14 cents per share, you will need to pay out $14.
Doesn’t seem like a lot, but if you owned 1,000 or even more shares of XYZ, it becomes a bigger deal.