Selling Stocks Short

Selling short involves borrowing securities or stocks you believe will decline in value and then selling them. Keep in mind; you are selling securities you do not own. Put another way, short selling is about selling high and then buying low, just the opposite of buying stocks or other investment securities. Once you have sold your securities, you hope that the price falls, in which case you buy them back at a lower price; the difference between your sell price and your buy price in this case is your profit. If the price rises, you may be forced to buy the shares back at the higher price, losing money on the transaction. Remember, you have to buy your shares back because you must return them to the brokerage firm.

In this article about the short sale we will discuss the following:

* What does it Mean to Sell Short?
* What Are the Potential Advantages of Selling Short?
* What Are the Potential Risks or Problems When Selling Short?

What does it Mean to Sell Short?

Let’s assume you are under the impression that the company XYZ is overvalued and set to decline. How can you profit from this decline assuming you are correct? Believe it or not, it is possible to profit from a stock’s decline by selling its shares short. To sell a company short, you “borrow” shares that you do not own from your broker and sell them on the open market with the intent of purchasing the same number of shares back in the future. Because the shares have been borrowed, you must at some point buy them back returning them to the broker you borrowed them from.

Here is a summary of how selling short works:

1. You borrow a stock or security from your broker.
2. You sell it on the open market in the same way you would sell shares in a company you own.
3. You buy the shares back when you believe the price has fallen sufficiently or when the broker compels you (whichever comes first).
4. You have now repaid the loan you took from your broker.

As an example, let’s say that you really believe that Widget, Inc. (XYZ), which is currently trading at $100 per share, is going to fall. You borrow 100 shares of XYZ from your broker and sell them on the open market for $10,000. Luckily for you XYZ does indeed see a price decline. Soon, the stock drops to $40 a share, at which price you decide to buy the 100 shares back at a cost to you of only $4,000. Because you sold the shares you did not own at $10,000 and were able to return them to the broker at a cost to you of only $4,000, you get to keep the difference as your profit. You come out $6,000 ahead (before commission and interest).

On the other hand, if Widget, Inc. does not in fact fall, but instead keeps on rising after you sold it, you will incur a loss. Let’s say it rises to $150. It will cost you $15,000 to buy those back the 100 you sold at $10,000. Thus, you incur a loss of $5,000; the difference between the price you sold the shares and the price you were forced to buy them back at.

What Are the Potential Advantages of Selling Short?

Investors sell stocks short as a way to profit during a declining market or as a way to hedge against losses for investments that they own.

Let’s say you are under the correct impression that the market is about to decline. You have the option of selling the stocks you own. By doing so you protect yourself against loss but if your account is sitting in cash during the market decline it is also not making you any money.

On the other hand, if you correctly believe the market is going to decline and you sell “borrowed” shares from your broker, your investment accounts will continue to gain money even as the market declines.

What Are the Potential Risks or Problems When Selling Short?

As with any investment strategy, there is risk. If you are incorrect and prices move up from the price you sold short, you may be forced to repurchase the borrowed shares at a price higher than you sold it for.

In addition, when you are short a security, you are responsible for paying any interest or dividends the company distributed to the investor you borrowed it from. Moreover, at any time the broker can “call in” the shares, requiring you to return them immediately regardless of the price at the time they make their demand. This can occur for one of two reasons; 1) the price moved up too much from your sell price, so the broker forces you to buy so that they do not incur a loss so large you are unable to repay, or 2) if the broker needs the shares back due to buyer demand.

It’s also important to remember when selling stock short that profit potential is limited if you are correct; if you buy a stock the upside potential is unlimited, but if you sell a company short, the downside is limited to 100% as a company can not be worth less than zero. The big however is that your loss potential is theoretically unlimited as the price can move up 100%, 200% or even 1000% or more after you sold short. This is the reason it is very important to use stop losses on your position when you sell short; or when you buy stocks for that matter.

Donald D Harder is an investment advisor with over 17 years professional market experience and is President and Chief Stock Market Analyst for Securities Research Services, an online stock trading newsletter service. Don served as a financial advisor for American Express Financial Advisors and later served on the board of directors at Nettrader.ru, a mid-sized Moscow-based online securities brokerage. Mr. Harder strictly adheres to an investment philosophy that focuses primarily on reducing risk, for if you manage risk, profits generally take care of themselves.

SRS is a one-stop solution provider that helps traders and investors maximize their returns from the markets with the help of a daily securities research services and stock trading.

What is Day Trading?

During the dot com era of the late 1990s a 20th century version of the California gold rush emerged as literally tens of thousands turned to the stock market lured by hopes of freedom and easy money. The vast majority of these hopefuls employed the technique now commonly known as day trading. Day trading simply and correctly implies that investment positions are opened and closed during the same day.

Day traders may buy a stock in the morning with the hope of selling it later in the day for a profit. Likewise, positions may be held open for a few hours, or day traders might buy a stock and sell it only minutes or even seconds later. In general, they do not hold a stock they have purchased overnight. A day trader’s primary focus is to profit from daily market swings.

How Much Can I Make?

Most who consider day trading as a career approach the subject with unreasonable expectations. It’s not hard to understand why since there is no shortage of advertisements on television and on the internet promising outlandish returns. Consider the fact that a mutual fund manager that consistently earns 40% returns per year for her clients would probably be afforded guru status among those who have been in the business for a while. Also consider the fact that mutual fund managers have access to much better information and are more experienced than the average retail day trader. There are day traders who are making annual returns of 70%-100% or more, but it is unlikely that an inexperienced trader can expect these types of returns their first year out.

Build a Foundation Before You Begin Trading

As with the late 19th century Californian gold rush, a few struck it rich and the majority lost money. The reality of day trading is that there are inherent risks and the unprepared are especially vulnerable to losing money. This profession is not for the faint at heart nor is it for the risk averse. Likewise, day trading is not a profession for the uninformed. Success takes knowledge, money, a good strategy and deep commitment. Simply opening a brokerage account and buying stocks without a plan for where to get in, where to get out and what to do if something goes wrong is a sure fire recipe for disaster.

Every buy in the stock market has a seller on the other side and every sell in the market has a buyer. Those who are unprepared to compete in this zero-sum environment very often find out the hard way that competition is fierce. To be successful you have to be smarter than your competitor because in reality you are in a competition to take their money away from them and they are trying to take your money away from you. If you are just getting started make sure that you are committed to spending the time and energy necessary to learn your new trade and to develop your skills.

Before you run out and open an account with your online broker and start throwing money at the market in hopes of making your millions, it is important to build a foundation of knowledge, make sure that you are properly equipped and make sure that you have explored the advantages and disadvantages. Following is a list of the very basics you will need to know, acquire and consider before you risk even one dollar in the market.

Pros and Cons of Day Trading

The business of buying and selling stocks and other investments throughout the day can be exciting, risky, rewarding and freeing. Day trading offers unlimited potential profits, but it also exposes one to high amounts of risk. When deciding whether or not to commit to this profession it is wise to look at the advantages and disadvantages to determine if one is ready and willing to take the plunge.

Forex

Despite popular misconception, it is not possible to get started in the business of day trading without first gaining some foundational skills and preparing the proper tools. Before even considering risking one’s money by day trading, it is essential to gain a proper understanding of the subjects in this article.

Equipment

Up until the last decade or so, access to the market and market data was limited to well-capitalized, large brokerage firms. In the internet age, information that was only available to the privileged few has now been made available to the masses, putting everyone on pretty much an equal playing field. Software and hardware needed to get started in the day trading business is widely available and relatively cheap.

SRS is a one-stop solution provider that helps traders and investors maximize their returns from the markets with the help of a daily Day trading and stock trading.

Top Stock Pick Strategies

Many investors and traders begin with the notion that there is a formula or system that if used correctly, will produce consistent returns in the stock market. Over the years, we have learned that top stock pick strategies, almost without exception, are those that stick with the very basics. There is no system or strategy that is going to earn consistent returns in all market environments. What worked yesterday, may not work today and what works today may not work tomorrow.



Trend Direction



Investors tend to behave like a school of fish. Like fish, who swim in unison, 70 percent of a stock’s movement is determined by the overall market trend. Any trading system will fail if it produces trade signals that run contrary to the market’s trend.



First, you need to determine if you are in a bull or a bear market environment. Generally, in a bull market, dips are bought and short sales fail, whereas in a bear market, selling pressure quickly meets each price rise.


The 200-day average is one of the best measures of a bull or bear market. If it is rising, the market is likely bullish and if it is falling, the market is bearish.



Pick Leading Stocks in Leading Sectors



When you trade stocks, you are competing against other stock traders. Every dollar you earn is a dollar you take out of the pocket of another trader. Very few people will be smarter than the millions of traders they are competing with. The smartest group out there are institutional traders who work for banks and large funds as they have large research teams who are experienced and have successful track records.



So, rather than try and outsmart the market, why not just follow the smartest people in the market?



Focusing on the leading stocks in the leading sectors allows you to see where smart money is putting their money to work, putting you on the right side of the trade.



Fundamentals Matter



Traders oftentimes rely on technical analysis, reasoning that a company’s fundamentals don’t matter over the short run. We’re here to tell you that fundamentals do matter.


Take the Chinese company RINO for example, In 2010, RINO broke out to a new price high on good volume, triggering a buy signal for technical analysts. Had they paid attention to the fundamentals, however, they would have noted an accounting scandal in the industry and a massive amount of institutional short interest in the stock.



A few lucky traders may have timed RINO correctly, but they were exposed to a massive amount of risk.



In order to avoid this type of risk, before we buy we make sure the company has great earnings, cash flow, relative strength and increasing institutional ownership.



Never Buy Above a Base of Support



Finally, once you have established trend direction, ensured you are buying only leading stocks in the top performing market sectors and you have made sure to focus on companies that are most likely to succeed due to great fundamentals, it is time to find stocks that offer a good buy point.



It does you no good if a stock meets the first three stock pick criteria if it is trading so far above a base of support it is unsafe to buy.



In the example above, we looked at the fundamental factors of the stock FOSL.



Now we want to see if FOSL has a chart that is as enticing as its fundamentals.



And indeed it does. It’s showing leadership as it breaks out to new highs on volume, it’s in a nice strong uptrend, and it is currently trading at a place where downside risk can be easily managed as it is trading directly at uptrend support.



Because we first checked to see if FOSL had strong fundamentals backing up the strong price action we avoided the pitfalls that bury so many traders in losses and because we bought FOSL where we could easily manage the risk we were able to enjoy quick solid gains.



Newsletter Service



You may have noticed that with other trading stock newsletters you are provided only the name of the stock and perhaps a suggested entry price. We understand how frustrating and useless this can be so we have attempted to make this process as simple and straight forward as possible.



With each selection you are provided a chart with a clearly defined entrance price, a clearly defined profit-taking price, and a clearly defined exit price where you are to stop out if something goes wrong.



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