Common stocks have historically outperformed many other investments over the long term. However, in the case of poorly run or unprofitable firms, common stock has the potential to depreciate as well. These are the stocks one seeks to capitalize on by selling short. Establishing a short stock position involves selling shares that you do not own in the open market. When you sell the shares, you receive cash into your account, and you are obligated to buy the shares at a later date in order to close your short position.
In order to short common stocks, you must have a margin account. As of November 10, 2010, per the SEC, if any stock has dropped 10% or more from the previous day’s close, short selling will be restricted.
Throughout the life of the trade, you will be required to hold in your account the entire market value of the security you shorted, plus additional funds and / or marginable securities to help cover your risk if the trade goes against you. To be clear, not only can you not spend the cash received from the short sale, but if the security rises in value, you will need to deposit additional assets to make up the difference. These requirements will be explained further in the section “TradeKing Margin Requirements.”
You might be asking yourself, “How can I sell something that I don’t own?” The answer is quite simple: you borrow the shares via your broker and promise to return the same number of shares at a later date when you decide to close your short position. Since you expect the price to go down in the future, you intend to close your short position by purchasing the stock later for less money than you sold it, pocketing the difference between the two prices. You can think of it as the inverse of the old stock adage, “Buy low and sell high.” When you are shorting common stock you actually want to “sell high and buy low.”
While the premise behind shorting common stock may seem simple, the reality is complex and fraught with risk. When you are long common stock, you have theoretically unlimited gains and you know in advance exactly how much you stand to lose: namely, your cost basis. You’ve already paid for your potential losses up front when you bought the stock. When you’re short a stock, you remain on the hook for cash you’ll need to come up with later, throughout the life of the trade. Here’s the real hitch: when you’re short, your potential gains are limited to the stock’s price at the time you sold it, whereas your potential losses are theoretically infinite. (Of course, it’s not every day a common stock goes to infinity. Even if it only goes to a gazillion, that would hurt too.)
The best way to deal with these sticky and potentially painful scenarios is to determine in advance just how much you’re willing to add to your cash or marginable securities (see Margin Requirements). That way, if you run into trouble, you’ve drawn your proverbial line in the sand and you’ll know to get out before things get worse.
When you’re short a stock, you face several different kinds of risk. First, you have market risk, which simply means the stock price may increase and work to your detriment. The higher it goes, the bigger the hit is to your account. You are also at risk of the company taking a corporate action while you are short the stock. This could be something simple like declaring a dividend will be paid, or more complex, like spinning off a company or issuing warrants. Either way, this is something that could cause your account significant pain if disregarded.
Dividend actions are a fairly common occurrence and should not be ignored. Once the record date for a dividend is established, the "ex-dividend date” ("ex-date") is usually set for two business days prior to the record date. If you are short the stock at the market close the business day before the ex-date, you will owe the dividend to the stock owner. In the case of more complex events, like a spinoff or issuing warrants, your potential losses can be substantial. Even though you shorted one stock to begin with, you could actually become short two stocks (or possibly more) at the same time. What’s more, both stocks have the potential to move against you.
Although less common, you could face two other risks if there are an overwhelming number of shares held short. First, the stock may become hard-to-borrow. If this happens, special rules and fees may apply. The other is the possibility of a buy-in. Both of these issues could cause you to exit your position prematurely, either as a result of your own action, or TradeKing’s if necessary.
Shorting stock can be a profitable play if the stock price is on the decline. Just keep in mind that the risks are more significant than a traditional long stock play.
Your time horizon may vary according to your investment objectives, skill level, risk tolerance and available capital. Traders may take a short position in a stock for very short or long periods, or any time frame in between. This could be a position trade (two weeks to six months), a swing trade (two days to two weeks) or even a day trade. Some traders feel that shorting a stock for longer may entail too much risk. Bear in mind, the more frequently you trade, the more transaction costs you will incur. TradeKing does not promote day trading.
If you are planning on a short-term trade and it isn’t working out, don’t give it extra time to perform. Get out according to your schedule and go on to the next trade. If you find yourself saying, “I’ll give it just one more week,” you’re probably guilty of breaking this rule.
When to Get In
You might consider shorting stock if:
- The stock is already on the decline, generally speaking. It’s usually a bad idea to short a stock that’s on the rise with the intention of nailing the height of an upswing, because it’s nearly impossible to pick the top.
- There are bearish technical indicators setting up for your stock.
- Fundamental analysis shows the financial health of the company is under fire and is no longer on solid footing.
- There is an unexplained shakeup in the company management
- Company insiders are selling shares in large quantities.
- There are negative rumors about an upcoming news announcement (earnings, for example) that’s anywhere from two to six weeks in the future.
- Using sector rotation, the company is in a sector or industry expected to face challenges in the next phase of the economic cycle.
Wall Street is not a laboratory, so analysis is not done in a vacuum. Feel free to combine methods to help you get in at the most opportune time you can determine.
When to Get Out
If you’ve sold a stock short, you might close your position based on any of the following:
- You’ve reached your profit target. Don’t get greedy. Get out before the stock has a chance to rebound.
- You’ve hit your figure for how much you’re willing to add to your cash or marginable securities. Get out before the trade spins out of control.
- Your predetermined stop-loss has been triggered.
- Fundamental analysis shows the financial health of the company is making a turnaround.
- There are bullish technical indicators setting up for your stock.
- Company insiders are buying shares in large quantities.
- Before earnings are released (or before some other upcoming event that’s been creating downward pressure).
- Using sector rotation, the company is in a sector or industry poised for growth coinciding with the next phase of the economic cycle
- There are upcoming events that might generate positive news.
- The ex-dividend date is approaching.
- There is an announcement of a corporate action (like creating a spinoff or issuing warrants, etc.)
- There is increasing short interest in the stock and you think it may become hard to borrow
- There’s a momentum shift and the stock begins to stabilize. Don’t try to pick the bottom. Get out before it gets there.
- You’ve given the stock adequate time to perform, and it’s not behaving as you expected. Stick to the planned timeframe.
Just because you’re in the trade, it doesn’t mean your hard work is over. It’s just begun. If any of the analysis you used to get into your trade shows signs of trouble, take action to reduce or exit your position, if warranted. You’re responsible for knowing the timing of upcoming earnings announcements and dividend actions. Be sure to check news for the symbol you’re trading incase a merger, spinoff, major lawsuit or the like is announced. It’s important that you thoroughly understand all of the news related to your stock, which is sometimes no small feat.
Shorting common stock is a high-maintenance play that requires a lot of discipline. Whenever you’re short, you need to keep a close eye on the market. Be prepared to put in significant time managing this trade, and don’t get in unless you can handle the theoretically unlimited risk.
You must keep a short leash on this trade. It can’t be overemphasized that you must approach every trade with a predetermined stop-loss. Some traders think somewhere around 5-7% is an acceptable range, depending on the volatility of the stock. Because your potential losses are infinite, you must be extremely disciplined about sticking to your stop-loss.
It can be extremely tempting to stick with a losing trade and hope things will turn around. Don’t give in to such an inclination. If your stop-loss is about to be triggered, or you’re nearing your personal margin limit, don’t give the trade more room to go against you. Exit the trade. Don’t rationalize or make excuses; buy back the stock. If it changes direction and goes on a bearish dive later, don’t beat yourself up. Just stop getting quotes on it and move on to the next trade. Of course it’s important to consider transaction costs when trading. But don’t let them sway you to stay with a losing trade that is no longer in your comfort zone.
You also need to be vigilant in watching for positive price movement in the stock, because this may change margin requirements in your account. You must remain in a position to add to your cash or marginable security holdings if there is a margin call, so you don’t get forced out of the trade under unfavorable circumstances. That doesn’t mean you should overstay your welcome if the trade is going too far against you. Don’t ignore your predetermined risk limit.
It may be wise to enter a buy stop order, GTC (good ’til canceled). That can help take away some of the stress of theoretically unlimited risk, and prevent you from acting on emotion and convincing yourself to stay in the trade when logic dictates it’s time to get out. However, please note this will not protect you from gap risk if the stock opens up sharply overnight or if trading is choppy during the day. Gaps may result in losses in excess of your predetermined amount.
Each stock has a figure known as its “beta.” This is the percentage that the stock price is expected to rise or fall as its benchmark index (commonly the S&P 500) rises or falls 1%. If stock XYZ has a beta of 1.5, then it will be expected to go up 1.5% if the S&P 500 rises 1%, or fall 1.5% if the S&P 500 goes down 1%. That means it is 50% more volatile than the market at large. Knowing your stock’s beta can give you some indication of its volatility compared to the broader market.
Some stocks are more volatile than others. You need to be certain that you have the gumption to run this play. If you don’t, then don’t kid yourself. There are many other plays that leave you at far lower risk of ulcers.
TradeKing Margin Requirements
If you understand the risks, short common stock requires a minimum of 150% of the stock’s value to remain in your account, consisting of 100% of the security’s market value plus 50% of the initial value of the shorted security. The maintenance requirement is usually 140% of the current value. These requirements could increase due to market volatility, fluctuations in the stock’s value, concentrated positions, trading illiquid or low-priced securities and other factors. Not all securities are available for shorting.
If the equity in your account is not sufficient to meet these requirements, you will be required to increase your cash or marginable security holdings to ensure you have sufficient collateral to repay the loan. When this happens, it’s known as a “margin call,” and TradeKing will instruct you to adjust your holdings over the life of the trade.