One of the main reasons people invest is because, over time, stocks tend to rise. Since 1950, major U.S. stock indexes have generated positive returns in every decade save the 2000s.1
Even when the market is up, however, some individual stocks still suffer, laid low by bad management, a poor business plan, increased competition, new regulations, or other factors. These are the stocks most investors try to avoid—most, but not all.
Unlike buy-and-hold investors, traders often try to participate in the market’s downs as well as its ups. Some traders even seek out stocks that appear poised for a decline and then attempt to profit from them. This strategy is called "short selling." It is achieved by selling borrowed stock at today’s share price, purchasing the shares in the future when, as hoped, its price dips and pocketing the difference.
If the stock declines as expected, the trader will come out ahead. But if the stock rises instead, the trader could suffer significant losses.
Kevin Horner, a senior specialist with Schwab’s Trading Services Education team, says that the biggest risk of short selling is that there’s no ceiling to the price at which the stock could trade in the future.
When you’re long on a stock—that is, when you buy it and hold it—and it drops to zero, the most you can lose is 100% of your investment. If you’re selling short, however, the stock price can theoretically keep on rising. That means your loss can exceed the amount you invested.
"In essence, the risk of shorting is unlimited," Kevin says.
Most investors would find the idea of unlimited losses off-putting—regardless of a trade’s profit potential—but even traders like Kevin, who describes himself as bullish, might find occasion to short a stock. "Occasionally I take a bearish position if I feel like the market is taking a turn for the worse and there’s nowhere to hide," Kevin says.
Even if you believe a stock is poised for a decline, there’s more to short selling than identifying a trade candidate. Given the potential for never-ending losses, "you have to be a lot more disciplined about protecting a short position than you do a long one," Kevin says.
Here are four steps to consider before shorting a stock.
1. Identify a strong candidate to short
Kevin prefers to short stocks he has already been tracking. But he’ll also use a screening tool to identify short candidates. "I look for stocks falling through a series of lower lows combined with higher volume, which signifies that sellers are running the show," he says.
Kevin also searches for stocks that have rebounded from a clear downtrend in tandem with an overbought signal. "I look for stocks that have rallied to the upper band of the trading pattern and appear to be set to lose steam and fall again," he says.
Even after identifying a candidate to short, Kevin waits to confirm a downtrend. "My goal is not to predict a move in the bearish direction but get involved after it’s already moved lower," he says. "I can miss the first 10% of a negative move and still be profitable."
2. Protect your order
The most important component of a short-selling trade plan is implementing some kind of protection for your order.
A buy-stop or trailing buy-stop order can help to manage loss on a short sale. In a short sale, a buy-stop order triggers a market order to buy the shares back when the ask price reaches the stop price entered. A trailing buy-stop order will readjust the trigger price if the stock moves lower.
"When I short, I always have a stop order in place to help protect against a price spike," Kevin says. "I want the market to tell me I’m wrong very quickly."
If the technical signals look appropriate, Kevin will set his stop trigger prices so that his loss is limited to one-third of his profit target. For instance, if his aim is to repurchase the shares $6 below where he sold them, he will set his stop price $2 higher than the stock is currently trading. Of course, it’s unusual to get clear technical signals so traders must be nimble and adjust their trades accordingly. Also keep in mind that there’s no guarantee that a stop order will be executed near a stop price.
3. Understand the nuances
Shorting stocks involves some not-so-obvious risks that could add to your costs or make shorting a specific stock impractical. For instance, if the stock pays a dividend, the short seller may be responsible for paying it. This can add to the cost of a short sale and reduce the potential return from the trade.
Further, shares may be difficult (or unavailable) to borrow in the first place. It’s wise to avoid shorting such stocks, Kevin says, because you may later be forced to repurchase the shares at an undesirable price.
Kevin also looks at the amount of "short interest" in a stock—that is, how many shares of stock have been sold short—before deciding whether to short it. When there’s a relatively high level of short interest in a stock, any positive news can cause a spike in the stock price as traders hurry to buy shares to cover their short positions.
"Generally speaking, I want to short stocks that are very actively owned and traded because it may reduce these risks," Kevin says.
4. Be prepared to get it wrong
It’s impossible to eliminate all short-selling risks. Traders should be prepared to be wrong more than they’re right, and should build in trade protections for this eventuality.
"With short selling, being disciplined is very important," Kevin says. "More than anything, you want to make sure you lose as little as possible when you’re wrong."
Short selling at Schwab
In order to short a stock, you must be able to borrow shares of that stock through a margin-enabled account.2 To find out about adding margin to your account, call 866-663-5250 to speak to a Schwab Margin Specialist.
Once approved, the amount you can borrow depends upon the type and value of securities in your account.
- To begin borrowing at Schwab, you must have at least $5,000 in cash or marginable securities3 in your account.
- The amount of money you can borrow on margin is typically limited to 50% of the sale proceeds in the account prior to a trade's settlement. For example, if you sold short 100 shares of a $20 stock, for $2,000, you'd need to have $1,000 in your margin account at that time. It's also important to know that you'll be charged interest on the value of the stocks you borrow in a short sale.
- After the sale is settled, you need to keep enough cash or securities in your margin account to cover at least 30% of the stock's market value.
1. Federal Reserve Bank of St. Louis FRED database, as of 6/15/2016.
2. Short selling is not permitted in retirement accounts.
3. Not all securities are marginable. The main types that are not marginable include mutual funds for the first 30 days of purchase; unlisted, low-priced, or illiquid equities; and low-rated corporate bonds.