Published in: Stocks

How to short stocks?

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How to short stocks?

First Published date: 29. August, 2022
Last Updated: 2. February, 2023
Fact-checked by Adrian Müller

When you’re trading stocks, you typically count on the value rising. However, you can profit when the value falls – this is referred to as shorting stocks. That being said, shorting a stock has its benefits and risks.

This guide will teach you about shorting stocks and provide some practical and helpful tips. We’ll also talk about the risks associated with shorting stocks. So, without further ado, let’s jump right in.

Understanding Shorting A Stock

Before you can master shorting stocks, you must understand shorting. The main idea is relatively easy. Investors who short a stock make money when the value decreases.

In practice, an investor will borrow a stock or security. Then they’ll sell it in the market and repurchase it for less than what they paid. The price difference is their profit.However, doing so is easier said than done.

Shorting is an advanced strategy. So, complete beginners should be cautious. Now, that doesn’t mean you can’t learn it. There are plenty of high-quality materials, like Trading for Beginners.

Investors, traders, and portfolio managers use short-selling in different ways. Traders might use it for speculation. In contrast, portfolio managers might use short-selling as a hedge against risks. You can learn more about hedging and how it works here.

One key thing to remember is that the risk can be limitless. Since you’re expecting the value of the security or stock to fall, if you’re wrong, you’ll suffer losses if the value rises. The value of security can keep climbing indefinitely, in theory at least.

Shorting Stocks: Options

Now that you know what it means to short a stock, we can talk about more concrete examples. This guide will discuss three kinds of securities: options, mini futures, and CFDs. First, let’s see how shorting stocks with options works.

Shorting stocks with options works slightly differently. With options, you’ll have a time limit on your short position.

Therefore, shorting options is best for short-term trading. This is because when the time frame expires, you’ll need to do one of two things – either close the position or pay the contract’s obligations. There are a few ways to short-sell options:

Put Options

Put options are simple. It’s an easy way to short-sell stocks with options. But you must give it time, as time decay works against the trader. It’s best to provide it for at least six months.

Traders aiming for less than six months can go for ITM options. However, ITM options are expensive, and you’ll need to be careful.

Covered Put

In covered put options, you short a stock and sell it “out of the money.” It should be directly proportional to the number of shorted shares. Covered put allows you to offset the market position fully.

As a result, you can enjoy some profit when the stock reduces in value. Unlike put options, the time decay for a covered put works in your favor.

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Short Call Options

This tactic is better for beginners. Although it’s easy to understand, there’s a higher risk involved. Short call options are essentially contracts between a buyer and a seller. In this contract, the seller must sell a particular share before the expiration date.

The price is also determined in the contract. However, the seller must sell it at that price before the expiration date. Remember that short-call options are bearish. It has limited advantages. But the risk is relatively high.

There’s also a cap on how much profit you can make. Traders will make profits equal to the premium of the short call. In addition, the position will gain value the closer it gets to the expiration date.

Shorting Stocks: Mini-Futures

Mini futures are a fraction of the size of a standard contract. You’ll often hear the term E-mini futures. As the name suggests, these are traded electronically. Traders can trade all kinds of assets with E-mini futures.

Mini futures can be used to trade currencies and commodities. However, indexes are commonly traded with mini futures – for example, the S&P 500 index. Indexes are methods of tracking the performance of an asset group. Another popular index is the Dow Jones Industrial Average.

They can act as a benchmark for performance. As such, they’re an essential tool for any investor. You can click here to learn about indexes.

The great thing about futures is that you can trade as much as you like. However, you must meet the minimum requirements. Shorting micro-E-mini-index futures requires the trader to have a healthy balance. Shorting mini futures creates a level playing field for traders since you don’t have to borrow.

Shorting Stocks: CFDs

Contract for Difference (CFD) has transformed trading. CFDs are the ideal way to make profits when short-selling. CFDs have leverage, which can multiply the returns significantly.

However, the risks are also high. That’s something you should keep in mind. Shorting stocks with CFDs is also simpler.

The first benefit is that you don’t need as much capital or margin. However, you can’t short CFDs if any of the following is true:

Only 10% of the security can be shorted
If the security is under a takeover offer
The order price is lower than the sale price
If the security itself isn’t an approved short-sale product or ETF

Our Tips For Shorting Stocks

To perfect short-selling, we have curated some tips. These will help you become a better trader. Since short-selling is intimidating to beginners, you can use these tips to give yourself a better chance at success.

However, you need to remember that all trading has inherent risks. The risks involved in short-selling are even higher because the value could go up indefinitely. These tips will help you move in the right direction.

1. Avoid Shorting Expensive Stock

Shorting an expensive stock is very risky. Some expensive securities might come down in price. That’s when you can think of shorting them. However, some stocks are unbelievably priced.

Even if the market may not look for a particular stock, you’ll need to look at the historical performance. The price will go up if the stock has done very well overall. As we mentioned, there’s no limit to how much they can go up. That’s why you should always avoid shorting expensive stocks.

2. Don’t Short Sell In Strong Industries

By nature, some industries are resilient to market ups and downs. These are the industries you need to avoid when short-selling. We aren’t saying that you can’t buy trade shocks, options, CFDs, and Futures in these industries. They can be great additions to your portfolio as a trader.

But since you’re short-selling, you’re counting on the price going down; it’s a bad idea to short in strong industries. The chances are meager. As a result, you could end up suffering significant losses.

When short-selling, look at three metrics – the market, the stock itself, and the industry. To be safe, you should short-sell when these three show weakness. It’s better to back out if any of the three shows strong signs.

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3. Pay Attention To The Detail

If you’re an experienced trader, you already know this. However, many beginner traders must remember to read the fine print. Don’t simply glance over it – this is a mistake. If you’re working with online brokers, some of them may outright refuse to sell the stock if you short it.

And you’ll need to buy it before they agree to sell it. Some brokers require you to have a higher balance to short-sell. All these little nuances are essential things to keep an eye out for.

That’s why, before you short-sell (or sign up with a broker, for that matter), always read the fine print. Reading the terms and conditions will keep you safe from any nasty surprises.

4. Don’t Be Greedy

Short-selling is inherently risky. You shouldn’t count on the value decreasing. Furthermore, short-selling is only permitted under certain circumstances. The market will always go back to its upward trend.

Hence, it shouldn’t be used as a primary strategy. Being greedy can cause significant trouble as well.

Try not to make emotional decisions. If a possible short sale seems too good to be true, it probably is. You should have a strategy on how you plan to short-sell while keeping in mind your risk management.

A solid risk management strategy will assist you in avoiding greedy and emotionally driven short sales, which can cost you a lot of money later.

5. Keep An Eye On The Market Trend

When short-selling, you should capitalize on market trends. When the market is trending downward, it’s your best time to short a stock. Additionally, a bear market is an excellent opportunity to short-sell.

Therefore, you’ll need to understand the market and keep up with current trends to identify these patterns. That’s how you can make the most of it at opportune times. However, you should also know when not to short a stock.

If the market is trending upward, this will be a terrible time to sell short. All these indications can help you make the right decision.

6. Don’t Short Big Story Stocks

Some stocks attract the media and press all the time. You should avoid short-selling these big story stocks at all costs. Since they attract many investors, they can have very high short-interest rates.