While brokers are able to handle most short selling requests, shorting a stock is more complicated than going long or buying options. In fact, there are some major issues involved with short selling that you must understand before you attempt it. So don’t even think about short selling before you’ve read this.
Keep reading to learn 10 things you must know before you short a stock.
You Can Use a Short-Selling Strategy in Today’s Bull Market. As long as individual stocks become overbought — and some always do — you may profit by shorting stocks with the help of ConnorsRSI. Even during this strong Bull Market, we just saw a period of one entire month — from May 21 to June 24 2013 — when the S&P 500 dropped 5.6%. Read our new guidebook Shorting Stocks with ConnorsRSI to learn more.
#1 Risk
In a long position, the most you can lose is 150% if you borrowed on margin to leverage your investment. With a short position involving the borrowing of the stock, your theoretical potential loss is unlimited.
If you borrow a stock when it is trading at $10 and the stock runs up to $200, then you’re out $190 a share — 19 times your original investment! Not a good thing.
#2 Finding the Stock
You may want to short a stock that is hard to find. The process of finding shares is called a “locate.” If your broker cannot find them, then you cannot short the stock.
Some stocks are hard to short because their shares are not easily available to borrow, which could happen for a variety of reasons. If you are finding it hard to locate the shares to conduct the transaction, it likely means that the stock is not held by a large number of individual shareholders (more on this in #3) or that there is a large short position in the stock already (more on this in #4). It is also virtually impossible to short a stock with a price under $5, and you cannot short a stock within a specified period from its IPO, depending on the exchange the stock trades on.
#3 Liquidity
You should not short a stock that is not highly liquid, i.e., there are many millions of shares outstanding.
Without liquidity, you can be right and wrong at the same time — right about the stock going down but stuck in such a way that you cannot quickly liquidate your short position and get the profits you deserve. Liquidity should be a prime consideration when establishing short-side positions.
#4 Outstanding Short Position
This is the number of shares of a company held short, measured in absolute numbers, or as a percentage of the float of the stock.
If this position is large, more than 10% to 20% of a company’s shares, the word is out and the bad news is already incorporated in the stock price. For the most part, I avoid stocks with large short positions, and so should you.
#5 Margin Account
You need to open a margin account to short a stock. It is in this account that the funds from your sale of borrowed stock will be placed.
But don’t count on collecting interest on this money. Not only will your broker charge you on the borrowed shares at the broker loan rate based on the price of the stock when you borrowed it (unless you are Warren Buffett or the CEO’s cousin), they will not pay you interest on the funds in the account or sweep it into a money market fund.