When it comes to the stock market and short selling , there’s a fundamental strategy that most traders think of: buy low, sell high.
But that’s not your only option when approaching the markets. You can do just the opposite — buy high and sell low.
It’s called short selling.
New to short selling? You’re in the right spot. And no, this isn’t a new way to trade stocks. Traders have been using this strategy in the U.S. stock market for over a hundred years.
In this post, I’ll give you the skinny on short selling: what it is, how it works, and key considerations for this trading style.
Short Selling Defined
Short selling is a trading method. You seek out stocks that you believe will lose value, aiming to ride the decline’s momentum.
How Short Selling Works
When you short stocks, you don’t technically buy the stocks … Instead, you borrow the shares from your broker. Then you sell the shares, which leaves you in a negative position.
Let’s look at an example: Say you want to short Company X. You borrow 1,000 shares from your broker. Those stocks aren’t really yours, so your share amount is still technically zero.
When you sell that stock, your account goes to -1000 (that’s a negative sign). It can seem odd to have a negative balance, but it’s all part of the short-selling cycle. There’s still more to process … on to the next step.
Now you have to buy back the shares you sold and return them to your broker (remember, you borrowed them).
But how can you potentially profit?
If the stock price falls after you sell the borrowed shares, you can buy them back at a lower price. Your profit is the difference between the prices at which you bought and sold the shares.
So, let’s go back our example of Company X. Say you sell 1,000 borrowed shares at $10 a share for $10,000 total. If the stock’s price falls to $9, you can buy 1,000 shares at that price — spending $9,000.
Quick breakdown: Sale price ($10,000) minus the buyback price ($9,000) = Your profit ($1,000).
Of course, that’s just an example. In short (forgive the pun), short selling is still buying and selling stocks. The process is just kind of opposite from the norm.
Short Selling Is Legal
A lot of traders think short selling seems sketchy at first glance. But it’s actually a long-standing tradition.
This trading method started in the Netherlands as long ago as the 17th century. Traders in the U.S. markets have used this strategy for more than a century.
Yes, it’s totally legal to short sell. And, in case you’re wondering, it’s ethical too.
How to Find Stocks to Short
While short selling is a legit trading technique, it won’t work with every stock. Just like any technique, you have to research to find candidates. Here are a few things to watch for when you short stocks:
- Stocks that are up for no good reason: If a stock is up without a strong catalyst, you may facing a ‘pump and dump.’ That’s when share prices inflate without a solid reason … and often what goes up must come down.
- Momentum investors drive the stock up: Momentum trading can make it difficult to value a stock. If momentum investors cause the price to go up, a dip may follow.
- Sympathy moves: Sometimes stocks move together, usually within the same sector. It can be a result of a sympathy play. Trading activity can be connected when you’re looking at the same industry. Sympathy plays can cause temporary spikes, and they tend to be short-lived as there’s no direct catalyst.
- Weak financials following strong trends: If a company tries to ride a hot trend but has bad financials, it’s probably not a wise choice for long positions. But it might have promise for short selling, especially if the trend isn’t likely to hold.
What to Consider When Short Selling
When it comes to trading, short selling isn’t the typical approach. Here’s what you need to keep in mind for this strategy:
Brokers: Not every broker offers short selling as an option. If you want to short sell, check if your current broker offers the service.
You can’t find shares to borrow: Brokers that provide short selling services don’t have to make every stock available for borrowing. There’s no guarantee you’ll get the shares you want when you want them, period.
Losses: Just like any move in the market, short selling can result in profits or losses. You’re borrowing the shares, so you have to return them to your broker — no matter the share price. If the stock goes up instead of down, you lose money.
It’s not a long-term strategy: Since short selling is generally pretty risky, it’s usually only used as a short-term strategy.
Bear markets can come with more opportunities: Bear markets may create more short selling opportunities, especially if the vibe is less than optimistic.
SwingTrades with Paul Scolardi
Hi, I’m Paul Scolardi. I specialize in finding momentum stocks before they hit the mainstream and skyrocket up.
I strive to find strong contenders for swing trades, buying low and selling high.
Want to learn more about swing trades? Join my SwingTrades program. My students learn to think for themselves in the market. I teach them my approach to the market and strategies for finding peak-potential stocks — before they start to rise. Join us today!
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