What To Consider Before Short Selling Stocks

Shorting stocks is an unfavorable long-term investment idea, mainly because markets tend to rise in the long term.

But there are day trading strategies that involve short selling. Shorting stocks intraday creates the significant potential to grow an account.

What Is Intraday Short Selling?

Intraday short selling is a speculative trading approach where day traders expect declining stock prices. A day trader borrows the shares to open a short position.

How Short Selling Works

You expect that the price per share of company XYZ will decline significantly intraday. Currently, the price per share is at $120. You identified a reversal pattern and expect the price per share to fall to $115 before the market close. You decide to short 100 shares of XYZ.

Before you place your order, you need to check if the chosen stock is available for shorting. If your stock is on your broker’s borrow list, the stock can be shorted easily and without borrow fees when trading intraday.

Your order is: sell short 100 shares of XYZ with a limit of $120 per share. Once the order is executed, you have a short position of -100 XYZ shares for the price of $120 per share.

The idea behind this concept is to buy back the shares later once the price declines. A profit is made if the short position is covered later at a price below $120 per share.

Scenario 1:

Short selling works in your favor, and the stock reaches the target of $115 intraday:

Original value of borrowed shares: $12,000 (100 shares x $120)

Value of borrowed shares after they are bought at the current price: $11,500 (100 shares x $115)

Profit: +$500 (12,000-11,500)

Scenario 2:

Short selling works against you, and the stock moves to $123 at market close:

Original value of borrowed shares: $12,000 (100 shares x $120)

Value of borrowed shares after they are bought at the current price:-$12,300 (100 shares x $123)

Loss: -$300 (12,000-12,300)

Short positions should be covered by the latest at market close. Otherwise, you need to pay borrow fees for holding shorted shares overnight. And even more importantly, short-selling comes with unlimited risk.

Scenario 3:

The short position was held overnight, and company news led to an unforeseeable sharp price increase to $200 per share.

Original value of borrowed shares: $12,000 (100 shares x $120)

Value of borrowed shares after they are bought at the current price $20,000 (100 shares x $200)

Loss: -$8,000

Even if it is very unlikely that scenario 3 will occur, they do happen. Some of the most recent examples are GameStop (GME), Koss (KOSS), and Nokia (NOK).

Limitations Of Shorting

Many brokerages in the United States have an easy to borrow list with about 3,500 stock symbols. Most S&P 500 and Nasdaq 100 stocks are on that list, plus hundreds of other high-liquid stocks. Some direct-access brokers offer a broader list plus the opportunity to borrow the so-called hard-to-borrow shares for a fee. However, those stocks have to be located, the fees can be extensive, and the rules are different from broker to broker.

Margin trading enables traders to leverage the capital on the account. While most brokerages allow their clients to open positions worth four times more than the deposited amount, short selling may lead to lower margin tolerance.

Another limitation is the pattern day trader rule, which affects day traders in general. You need a maintained minimum of $25,000 to day trade stocks.

Finally, the uptick rule is another limitation when shorting stocks. This SEC rule says that if a stock falls more than 10% on a particular day, it can only be shorted after an uptick.

Risks Of Shorting

Because stocks can theoretically rise forever, the main risk of short selling is that losses are unlimited. Look no further than several recent examples:

• In 2020, Tesla (TSLA) went from $84.90 to $705.67.
• Between Jan. 1-Jan. 27, 2021, GameStop (GME) went from $19.00 to $347.51
• Bed Bath & Beyond (BBBY) started 2021 at $17.97 and on January 27, 2021 it closed at $52.89

Anybody who was short those three stocks over those time periods lost a lot of money. 

Only Long, Only Short, Or Both?

The answer to this question is not that easy and varies from trader to trader. 

Like with any trading strategy, shorting depends on your mentality, mindset, and ability to apply rules and parameters.

Shorting stocks opens the door to a new world of trading strategies and tactics. Most people will fail to do both since one particular event can trigger both directions. If we use the breakout to a new daily high as an example, you can buy that breakout, and you can short that breakout. If you consider trading in both directions, you may be undecided or make the wrong decision for various reasons.

The best solution to decide whether to go the traditional route of going long or the more advanced route of shorting socks is by executing trades in a simulated environment.

Execute a few hundred trades intraday and analyze the result by looking at the performance of your long trades and short trades. Look at the number of trades, profit per share, win/loss ratio, holding time, and the overall performance. The chances are that you will have a clear favorite once you analyzed the data.

It is important to start with a due diligence process to find out what shares can be shorted using your broker and what specific fees and rules are applied. It will take a while to get used to short selling tactics, but it will be worth investing in analyzing this trading style in most cases.

Traders should use a simulated trading account to test short selling tactics. Also, various chart time frames should be used while testing the typical market behavior and multiple trading strategies. It is important to analyze simulated trading results before making a final decision.