Short Selling 101: How-tos, Pros and Cons
Short selling is an investment strategy used to take advantage of the bear market, but it comes with considerable risks. Traders can short a stock, a market, or a commodity, etc. via exchange-traded funds (ETFs). It is not designed to “buy and hold” but rather it is a short-term strategy. Short sellers could end up losing an infinite amount of money, therefore traders should think twice before taking the leap. Read on to find out more about how to short sell, its advantages and disadvantages.
What is short selling?
Short selling is an advanced investment strategy for experienced investors and traders to profit from stocks that decline in value.
It flips the conventional idea of investing i.e. buy low and sell high. Conversely, it is "buy high and sell low", betting that the stock price will decline. The trading is done through brokers that offer this service. To short a stock, investors need to first initiate a position by borrowing shares from a broker and you must buy the shares back in order to close the trade ideally at a lower price to repay the loaned amount to the broker.
If the price drops after the investor short sells the stock, the investor will then buy it back at a lower price and then return it to the lender. The difference between the sell price and the buy price will be the investor’s profit.
If a stock’s price increases, the investor will lose money. One of the biggest risks of short selling is the possibility of losing an infinite amount of money as there is no ceiling as to which a stock price can rise.
How can short selling make money?
Short selling can be a good investing strategy to earn money in bear market. Investors who short sell in a falling market can earn a positive return. First, short sellers borrow shares of stocks from a brokerage. Then, they sell the borrowed shares at current market price and receive the income earned from the shares sold. Short sellers would then have to decide whether to close out the short sale by buying the exact number of shares sold to return to the brokerage, in the hope that the stock price would drop when they buy the shares such that they can earn the price difference.
For example, if an investor thinks that ABC stock is overvalued (current price: $150/share), and its price will drop. He or she can employ the short selling strategy to make profit. The investor needs to borrow some shares, say 10 from their broker and then sell them.
If the stock does go down to $100, the investor could buy the 10 shares back at this price, return the borrowed shares to their broker, and make $500 profit ($1,500 - $1,000). However, if the share price increases to $200, the investor would have to pay a higher price to buy back the shares borrowed, making a loss of $500 ($2,000 - $1,500).
Please beware that short selling is high risk trading strategy and does not guarantee profits.
How to short sell?
After you have evaluated the risks of short selling, you may follow the steps below to short sell:
Decide whether you want to short shares or derivatives
Set up a margin account
Open a position to ‘sell’ the product you want to short
Monitor the market situation to determine if your prediction was correct
If the stock price drops, close your position by buying back the shares and earn the difference
If the stock price rises, close your position by buying back the shares and pay the difference
Pros of short selling
Potentially earning profit during bull market
Short sellers can benefit from a potential decline in an investment. Short selling can be used as speculation or hedging, to help protect gains or mitigate losses in your investment portfolio.
Little initial funds required
Short selling allows investors to earn a significant profit without substantial initial funds. Only the brokerage fee is required upfront, and the rest can be covered when you close the deal.
Cons of short selling
Risk of infinite losses
Theoretically, short sellers can lose an infinite amount of money because there is no limit to which a stock price can rise.
Risk of margin call
When the value of the securities in your margin account is running low, you will need to add additional funds into it to avoid a margin call.
What is an inverse ETF?
An inverse ETF is an exchange traded fund (ETF) consisting of different derivatives with the objective of delivering inverse returns of underlying indexes. Inverse ETFs only seek investment results that are the opposite of their benchmarks' performances for one day only. For example, if an inverse ETF seeks to track the performance of Nasdaq 100 index. Therefore, if the Nasdaq 100 index goes up by 1%, the ETF should drop by 1%, and the opposite also stands.
Want to invest in inverse ETFs?
Investing in inverse ETFs may lift your portfolio during a bear market. Open your brokerage account now to start trading!
Top Inverse ETFs
In a downtrend market, inverse ETFs are popular alternatives to short selling as trading inverse ETFs do not require the investors to own a margin account. As long as you have a brokerage account, you can buy inverse ETFs in an attempt to make profit from the decline in value of an index or benchmark tracked. Here are the top inverse ETFs in the marekt.
1. ProShares UltraPro Short QQQ (SQQQ)
The ProShares UltraPro Short QQQ (SQQQ) is a 3x leveraged inverse ETF which corresponds to the Nasdaq 100 focused on technology and telecommunications stocks with the aim of closely following three times the inverse (-3x) of the Nasdaq 100 index.
2. ProShares Short S&P 500 (SH)
The ProShares Short S&P 500 (SH) is composed of large cap U.S. equities and designed to correspond to the inverse (-1x) of the daily performance of the S&P 500.
3. ProShares Short UltraShort S&P500 (SDS)
ProShares UltraShort® S&P500 seeks daily investment results that tracks two times the inverse (-2x) of the daily performance of the S&P 500.
4. Direxion Daily Small Cap Bear 3X Shares (TZA)
The Direxion Daily Small Cap Bear (TZA) 3X Shares seek daily investment results, of 300% of the inverse performance of the Russell 2000® Index.
What does shorting stocks mean?
- Short selling is an investment strategy that benefits from the declines in value of an investment product.
Is short selling good for experienced investors only?
- Yes, it is an advanced trading strategy that should only be attempted by advanced and experienced investors who are knowledgeable with the market and familiar with the risks short selling carries.
Is a margin account required if I want to sell short? Can I engage in short selling without a margin account?
- Yes, a margin account is required for short selling. However, you can buy inverse ETFs, which produces similar effect to short selling, with simply a brokerage account.
What should I beware of if I short sell stocks?
- You should be aware of the risks involved in short selling stocks such as market risks and regulatory risks. Also, there is a potential for unlimited losses in short selling.