Short selling is a powerful tool to profit when the indexes or an individual stock declines. The mechanics of the process can be convoluted, but it isn't necessary to understand the complexities in order to make short-sale trades.
Technically, when you short a stock, you borrow the targeted stock through your broker and then immediately sell it. The goal is to eventually repurchase the shares at a lower price and return the borrowed shares to the broker. If the stock drops sharply, you can make a nice gain when you rebuy the shares you borrowed at a lower price.
There can be difficulty borrowing stock as there is a limited supply, and your borrowed shares may be "called" by the broker if the original owner wants them back. Some short sellers avoid these problems by engaging in illegal "naked shorting" when no actual shares are borrowed, but there are increased efforts by the SEC to prevent this.
The borrowing of shares to short creates a very different dynamic than merely buying. The limited supply can produce tremendous short squeezes like we have seen in recent years with meme names like GameStop (GME) , AMC Entertainment (AMC) , and others.
There is an aggressive trading community that specifically targets highly shorted stocks to try to create squeezes. When they are successful, the moves can be tremendous but are often of very limited duration.
Inverse ETFs are often used for short selling. Retirement accounts that are not allowed to short individual stocks can use an inverse index ETF. They can also be leveraged to produce even bigger moves. The Direxion Daily S&P 500 Bear 3X (SPXS) moves three times faster than the S&P 500, but there are some drawbacks to using inverse ETFs, such as time decay if they are used for extended periods of time.
Options are another way to profit from declining stocks. They provide more flexibility, but there are other complexities and risks.
5 Key Things to Know About Shorting
Here are five key issues to consider when shorting stocks.
1. Shorting is not as simple as the inverse of going long. Indexes and stocks tend to decline much differently than they go up. The most basic illustration of that fact is that rallies and uptrends last far longer than pullbacks and declines. There also is a natural tendency for stocks to go up over time. The market will often bail an investor out of a bad long position if they are patient, but that doesn't work as well with shorts. Bull markets have dominated the market action for the last century, while bear markets have been very abrupt and lasted just a relatively short amount of time.
2. Good shorting requires greater anticipation. There is an old market adage: Stocks take the escalator up and the elevator down. Bear markets and corrections tend to be much more abrupt and intense. Timing short sales requires much more precision than timing rallies and uptrends.
Traders that are effective at shorting tend to develop an entirely different mindset than those that primarily focus on the long side. Highly reactive traders can catch good short sales if they move very fast, but most short sellers are anticipatory and mentally prepared to be on the wrong side of a trade before it eventually works. They will lose money and incur opportunity costs while they wait, so if someone is used to immediate results, shorting can be extremely frustrating as things move against them. If they wait long enough, the market's natural cyclical nature may eventually reward them, but the timing can be tough, and the costs of fighting the trend can be substantial.
3. Don't short on valuation. The biggest problem that short sellers face is that it can take the market a very long time to recognize fundamental and valuation arguments. As the old saying goes, the market can remain irrational longer than you can remain solvent. That is especially true with short sales.
Suppose you believe that a stock is overvalued and likely to drop, the best approach is to wait for some weakness to develop and technical weakness to develop. Trying to catch the exact top in a stock is even harder than trying to catch the exact low and provides little advantage if the stock you are targeting really does have valuation and fundamental issues.
4. Avoid battleground names in bull markets. For years short sellers have targeted Tesla (TSLA) . The stock has had some substantial pullbacks along the way, but it confounded the bears who believed they had compelling fundamental arguments. Highly visible names are constantly targeted for short squeezes, but when market conditions shift then these high P/E growth stocks tend to be some of the best names to short. Be very aware of overall market conditions if you are going to pursue shorts in battleground names.
5. You don't have to short stocks in bear markets to make money. It can be very difficult for some traders to cultivate the mindset needed for trading. It is challenging to shift from the mindset that works for long trades to a more anticipatory mindset needed for short selling.
When the market suffers a correction, some traders are better off focusing on playing the inevitable counter-trend bounces rather than riding downside momentum. The biggest bounces always occur in the worst markets. Shorting allows traders to be more active in unfavorable market conditions, but more action isn't always the best move when things are challenging.Effective short selling can deliver big profits very fast, but like everything else in the market, if it was simple and easy, then you couldn't make big money doing it. It requires significant effort and the cultivation of the right mindset.