How You Can Profit as Stock Prices Fall

Shorting the market has always been a controversial strategy… but in many ways short sellers actually help the market. Viewed as a counterweight to the bullishness of Wall Street, short selling can be essential to price discovery.

In any market climate, short selling can be a great way to hedge losses in your portfolio. Let me show you how…

If you think a particular stock is going to fall, one way to make money as it falls is to short it. Simply put, to short a stock you “borrow” shares and then sell those shares at market value and pocket the proceeds. When the stock falls below the share price you sold at, you can buy back the borrowed shares at the lower price to give back to the owner (known as covering), pocketing the difference.

To short you will need to open a margin account with your broker.  Your broker will arrange the delivery of the borrowed shares.  There is often a ready supply of shares to be borrowed, usually owned by pension funds, mutual funds, or individual investors.

Finding the Right Stock

Finding the right stock to short can be a little bit tricky, but there are many aspects of a stock you can look at when finding the right stock to bet against. Generally, you want to make sure that the stock you are looking to short has high liquidity, which means that there are a decent number of shares being traded.

Some good signs of a short selling opportunity are when a company misses its quarterly earning estimates, its fundamentals are dwindling, sector trends are declining, or the stock is seeing high insider selling.

Too Good to Be True?

It all seems simple enough… you sell high, buy low, and then keep the difference.  But there are some risks when short selling that you need to be aware of.

As I mentioned earlier, in order to start shorting, you will need to open a margin account with your broker. There may be additional margin costs involved when you are shorting the market and you will have to pay out any dividends that were paid during the time frame you were borrowing the shares.

In the case of “hard to borrow stocks,” you need to also be mindful of the trading activities of the owner of the shares you are borrowing.   If he decides to sell his shares before you have covered, you will have to return the shares to him by either purchasing at market value or borrowing them from somewhere else. This is known as a forced buy-in.  Your broker will have a list of these companies.

Most importantly, unlike long investing where you can only lose what you invest, with short selling losses are hypothetically limitless.  If a stock you are shorting goes up, you will have to buy shares at the current price to cover your short, resulting in a loss. A “short squeeze” can cause a rising stock with short interest to rise even higher when fellow shorters are also attempting to cover their short.

High Risk, High Reward

Most investors won’t short stocks because they don’t know how or because they are scared.  While short selling does have high risk, you can also reap high rewards— especially in a down market. Picking the right stock to short can easily help you book fast gains. Just remember not to chase your short; set a price you will buy shares back at, and stick to it.

Have more investment questions? Please feel free to send any questions you have about investing directly to me at [email protected].

Sincerely,

Jessica Comitto
Associate Editor, Penny Sleuth

How You Can Profit as Stock Prices Fall was originally featured in the Penny Sleuth. Check out Wall Street’s 5 Most Profitable Penny Stock Patterns Report.

This story was originally featured on Penny Sleuth.

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