I generally look at the markets from a “buy to hold” (rather than a “buy-and-hold”) perspective. However, I recognize that there may be instances where it’s tempting to sell a stock short. While there is certainly potential for big profits, short-selling is a complex art and it’s important to know what you’re getting into before doing so. Here are a few pointers.
1. Have a solid reason why you expect the stock to fall
Are you counting on short-term downward movement for some reason, such as the stock trading above its historical valuations? Are you shorting because you see a fundamental flaw in the business? Did you hear about it from the “stock trading expert” over the water cooler at work (never trust your friend for stock advice)?
The bottom line is your gains are limited to how much a stock can fall, while your losses are only limited by how much it can go up before you close your short position. This means you’re counting on a lot of things working in your favor, and nothing unexpected happening that makes the stock price go up. This can include industry-specific and macroeconomic things that have nothing to do with the business, and that you can’t predict.
2. Have an exit plan
How much do you hope to profit from the short sale, and how much you’re willing to lose if the trade goes against you? Without these in mind, you could end up robbing yourself of profits by getting out too quickly or worse, hanging on to a losing trade for way too long.
For instance, if a certain stock trades for $100 per share and you feel its P/E multiple of 21 is too expensive because the sector’s average is 18, that could potentially be a good reason to sell a stock short. You determine that the stock should be valued at about $86, so you set your sell point at $90 to be a little conservative. And, you decide that if you’re wrong and the price increases to $110, you’re out – no matter what. This is an example of a well thought-out exit strategy.
3. The need for a margin account, and margins involve you paying interest
Because you never actually own the stock in question that you’re betting against (your brokerage merely credits you proceeds from the sale of stock) you will need to open a margin account in order to short a stock. Sometimes margin accounts can come with higher minimum equity maintenance rules than a cash account, so it’s something you’ll want to check with your broker
But the biggest thing to know is that when you’re borrowing money to bet against a stock you’ll be charged interest by your brokerage firm. Although lending rates will vary based on the brokerage, how active a trader you are, and how much money you have invested with your brokerage firm, today’s margin rates typically range between 7% and 10%. This means that not only are your gains capped at 100%, but you’ll also owe regular interest payments to your brokerage. These fees can seriously eat into your profit potential, and they’re just another reason why short-selling is considered such a risky activity.
4. Risk management
Investing in stocks includes the concept known as asymmetric risk. In essence, what this means is that while a stock can lose at most 100% of its value, it could also rise in value many, many times over.
In this way, one big winner can make up for a lot of losers in a diversified stock portfolio. When it comes to shorting stocks, however, this asymmetric risk profile is flipped on its head. That’s because if you short a stock, the maximum gain you can hope to achieve is 100%, which typically will only occur if the business goes bankrupt and its shares are deemed worthless. But your losses can theoretically be unlimited.
In this way, just one short position that moves sharply against you can wipeout gains on many of your other positions. This is a major risk inherent in short-selling stocks. Great care must be taken to size short positions according to your heightened risk profile.
In general, you will not see me recommending a stock that should be shorted. I tend to have a limited amount of resources to invest and there are usually more companies that I am interested in putting money into to increase that risk by shorting a stock.
You can read more on thoughts on investing by going to Before Shorting a Stock, Here Are 4 Things You Must Know — The Motley Fool