Thinking about shorting a stock for the first time and betting against the market? Consider these 11 points first featured today over at TradingMarkets (link) before you give it a go:
1. Risk – While with buying a stock you can only lose your investment, with shorting you can lose a whole lot more. Buy a $20 stock and watch it go to zero and you lose 100% of your investment, but short a $20 stock and watch it go to $100 and you just lost 500%.
2. Finding a Stock – Not all stocks can be shorted, so make sure to trade with a good online broker to give you the most flexibility.
3. Liquidity – Only short stocks that are highly liquid to make sure you can get out of the position when you want to.
4. Outstanding Short Position – If 10 – 20% of the company’s shares are already being shorted then the bad news is already out and other investors are already hopping onboard the bear train. These types of stocks are prone to short squeezes (explained further down, point #8) and should be pursued with extreme caution.
5. Margin Account – No margin account means no shorting stocks (read our article 9 Tips For Successful Margin Trading).
6. Margin Calls – Make a bad short and your broker may issue a margin call. Since they are lending you funds they have no interest in watching you lose 500% and then not be able to pay them back. A margin call forces you to either deposit more cash into your account or be automatically closed out of the position.
7. Early Sale – If the original owner decides to sell the stock you are borrowing against then you must replace it (note this is extremely rare so can really be ignored).
8. The Short-Squeeze – If a lot of buyers come in all at once and cause a stock to jump in price then all the shorts rush to cover as quickly as possible. A short squeeze is when a stock has a large outstanding short position and good news causes a mad dash to cover shares. Not fun for an investor who is short.
9. How to Cover – Make sure when covering the position you fill out the trade ticket correctly. Look for the option, “buy to cover”.
10. Dividends and Taxes – You don’t get to keep stock dividends, they are paid to the actual share owner, and furthermore all profits are short term capital gains so don’t expect to get a tax break by holding over a year.
11. USE STOP LOSSES – This is a golden rule for shorting stocks and I am adding it here as the 11th fact. If you dont use stop losses you will end up getting burned! Step a profit to loss ratio and stick to your rules.
Other great articles related to short selling: