When it comes to trading stocks, most people have heard the old maxim about buying low and selling high. When you sell short, the sequence is reversed: You identify a stock that you think will decline, and borrow it from your brokerage. Then you sell it with the expectation of buying it back after it falls and returning the shares to your broker. Your profit is the difference between the price at which you first sold the stock, and what you later bought it back for.
To sell short, you have to have a margin account with your brokerage firm. That’s an account that lets you borrow stocks using your own eligible securities as collateral. Selling the borrowed stock, or “selling short,” leaves a negative share balance in your account called a “short position.” When you buy it back, you’re closing out that position.
Let’s walk through an example. On March 7, this stock starts trending lower, breaking through the support level of 97 dollars on March 9th. As the stock continues to fall, you could take out a short position, borrowing 100 shares and selling them at around 84 dollars a share for a total of $8400.
While it’s unclear how far any pullback could go, placing a stop order just above the high of the last day would help a trader mitigate their risk if this were to rally. The trader has an opportunity to buy at a lower price as long as yesterday’s high isn’t violated.
In this case, the stock continues to trend downward. You could then buy back those borrowed shares, say when the stock hits 76 dollars, for $7600. That’s a profit of $800 on your short sale.
The most obvious risk of short selling is that the stock you expected to decline, rises instead. That would force you to buy it back at a higher price than you sold it for. And because there’s no limit on how high a price could rise, your potential loss is unlimited.
One way to attempt to control such risks would be to use a buy-stop order to limit the damage to the trade in the event of a large upward move. There are many methods for determining where to place your stop order. Some traders might place the buy stop just above a moving average, or above the most recent high price the stock achieved. This would represent a possible change in the behavior of the price action and the short seller might want to move on quickly.
Remember, though, that there is no guarantee that a stop order will be executed at or even near your stop price. To learn more about trading, watch more videos in this series and subscribe to our You Tube channel.
Shorting a stock enables traders to try and capitalize on declining markets. This video walks you through an example to demonstrate the basics behind short selling and how to mitigate the potential risks.