Short Selling 101

Short selling is a term used in stock trading when a trader believes that a stock is too expensive and he/she borrows it from a dealer(usually a broker) and sells it with the hope of buying it later at a lower price and returning it back to dealer. End goal is to pocket the profit due to price difference.

Here is a simple example to explain it.

You are following a stock XYZ trading at $50 and you believe it is going to fall to $40. You can do three things here. Go long on this stock and lose tons of money in a short period. You read it right, people do go long on stocks they don't have solid confidence. They have a gut feeling that they might lose but they still enter a trade due to greed. Let's hope you're not the type who picks this option. Second option is to just sit and wait until it start to recover from its slide and then go long. Third option is to sell it short and then buy it at $40 to close the trade. Let's say you decide to short sell 500 shares. Remember you don’t really own any shares, so you’ll borrow them from your broker. When you execute this transaction, your broker will create a balance of –500 shares in your account and will add sale proceedings to your account balance. So excluding trading costs, selling 500 shares at $50 will result in a balance of $25,000($50*500 = $25,000) in your account. This transaction is defined as “SHORT SELLING”.

Once you have entered a trade, real game begins. Since you have sold a stock short, you have to return those shares to your broker and there is no way around it. Let’s say that after two weeks, stock falls to $45 and you decide to close your short position. What you have to do is to execute a buy order for 500 share(cost = $45*500 =$22,500). After executing this order, those shares are automatically returned to your broker(remember you had a –500 shares balance in your account, so buying 500 shares will cancel out that balance). End result – you made a profit of $25,000 - $22,500 = $2,500. Pretty good profit in just two weeks.

If you take a cursory look, this transaction looks pretty good and you made a nice profit of 10% in just two weeks. But if you pay a little more attention to selling short, you will notice that it could have as easily gone the other way too. What would have happened if stock had gone to $60? How would you have handled it then? Let’s assume that you would have closed the position at $60. In that case, you would have paid $30,000($60*500) to buy these shares back and would have lost $5,000. This is a very simple example. Most of the time, people don’t want to admit that they have been wrong on a trade and continue to hold a short position, hoping for it to fall one day. That could end up being a investment disaster in the end.

As you can tell, most profit you can make on a short is 100%(if stock goes to zero), but the potential for loss is unlimited. So you have to be very careful if you want to experiment “Short Selling”. The most important rule of short selling that most people ignore is identifying “momentum move”. Never ever short a stock when it has just broken out of a trading range or new high. No matter how much you’re convinced that it is over priced. Here is one really good example.

Amazon.com(Symbol – AMZN) is a online retailer and if you trade tech stocks, you probably know all about it. AMZN traded between $35 and $45 for over six months between November 2006 - April 2007. Most people who traded AMZN during this time or before were accustomed to see a price between $30 and $40. However, when company reported solid quarterly results in late April with good guidance, stock moved up to $55(Breakout point 1 on the chart)in just couple of hours.
Stock continued to move up in next trading session as well with heavy volume and move from $45 to $63 in just two trading sessions. For some inexperience short sellers, this move was too much too quick and they jumped in between $61-63 range. As you probably know that a 50% move in two trading session is too much too soon and short position at this time sounded the obviously choice. A lot of individual investors shorted the stock and this short trade felt good for next 5 to 7 trading days when stock stalled around $63. This should have been the first red flag for short sellers. If stock fails to move down after a big move up, you should bail.

Also, volume was anemic on those down days, another sign that it is going through consolidation and can move up big again. Some smart shorts closed their positions with small gains or losses based on their entry points. However, some refused to admit that they were wrong and stayed in. Next big move came in with breakout 2 when stock moved from $61 to $74 in three trading days. At this point, if you thought that majority of short sellers were out, you're wrong. Short sellers who went short after $63 and closed their positions earlier jumped right back in. Their argument - If this stock was too expensive at $60, it is now way too expensive at $70. You can go to any stock message board and when short sellers are posting excessively on how expensive a stock is or how hard it is going to fall, that's your time to go long because there is a short squeeze coming. Anyway, new short sellers were trapped when stock moved again with breakout 3 and lost even more money.

What can you learn from this? First of all, let's make it clear that short selling does work and smart short sellers do make money and a lot of it. Short selling would have been long extinct if nobody was making money selling short. Trick is to figure out the right entry point. Anything that goes up too fast is bound to come down but you only want to be on short side when it comes down. Too often people enter a trade too soon on short side and sell too early when they on long side. It's not luck but it is just human nature that is driven by greed, hope and fear. IF you're tired of losing money by entering a trade too early and exiting too soon, here is the only piece of advice that you would ever need in stock market - "It is never too late to enter a trade".

If you're interested in selling short and want to make money doing so, here are couple of important pointers for you.

First of all, watch the volume. If you see AMZN chart, you will notice that volume was at least twice the normal volume on every breakout. You never want to go short when a stock breaks out with heavy volume - no matter how expensive you think it is. You should also pay close attention to volume on down days after breakout. An anemic volume on a down day is a clear indication that it is consolidating and about to move up again. Some short sellers mistake these low-volume down days as "stall" and start to believe that the "Run" is over. If you have been run over by stocks while going short, go back and take a closer look at those charts and you would see a clear pattern that you either didn't see or elected to ignore.

But there is a bright side too. Rather than going short, if you would have gone long, you would have made lot of money. So even if you're a short seller, either wait or go long until you find a break to the downside and then ride it down with your short position. Never sell short unless you see a breakout to the down side.