It's possible to make money when prices are going down—if you are willing to accept the risks.
One strategy to capitalize on a downward-trending stock is selling short. This is the process of selling “borrowed” stock at today’s price, then closing the deal by purchasing the stock at a future time. What this essentially means is that if the price drops between the time you enter the agreement and when you deliver the stock, you turn a profit.1 If it increases, you take a loss. Note that it is possible to short financial securities other than stocks, including ETFs and REITs, but not mutual funds.
Selling short is primarily designed for short-term opportunities in stocks or other securities that the trader expects to decline in price.
The primary risk of shorting a stock is that it will actually increase in value, resulting in a loss. The potential price appreciation of a stock is theoretically unlimited and, therefore, there is no limit to the potential loss of a short position.
In addition, shorting involves margin. This can lead to the possibility that a short seller will be subject to a margin call in the event the security price moves higher. A margin call would require a short seller to deposit additional funds into the account to supplement the original margin balance.
It is important to recognize that, in some cases, the SEC places restrictions on who can sell short, which securities can be shorted, and the manner in which those securities can be sold short.
There are significant limitations to shorting low-priced stocks, for example. There can also be ad hoc restrictions to short selling. To prevent further panic during the 2008 financial crisis, the SEC temporarily prohibited naked short selling of banks and similar institutions that were the focus of rapidly declining share prices. Naked short selling is the shorting of stocks that you do not own.
The uptick rule is another restriction to short selling. This rule is designed to stop short selling from further driving down the price of a stock that has dropped more than 10% in one trading day.2 Traders should know these types of limitations could impact their strategy.
A short trade
Let's look at a hypothetical trade to get a better sense of short selling. Assume that on March 1, XYZ Company is trading at $50 per share. If a trader expects that the company and its stock will not perform well over the next several weeks, XYZ might be a short-sell candidate.
To capitalize on this expectation, the trader would enter a short-sell order in his or her brokerage account.
When filling in this order, the trader has the option to set the market price at which to enter a short-sell position. Assume the trader entered a market short-sell order for 100 shares when the stock is trading at $50. If the order is filled at that price and the stock declined to $40, the trader would realize a $1,000 profit ($10 per share gain times 100 shares) less commissions, interest, and other charges.
Alternatively, if the stock rose to $60 per share and the trader decided to close the short position before incurring any further losses, the loss would equal $1,000 ($10 per share loss times 100 shares) plus commissions, interest, and other charges. Because of the potential for unlimited losses involved with short selling (a stock can go up indefinitely), limit orders are frequently utilized to manage risk.
Timing is important
Short-selling opportunities occur because assets can become overvalued. For instance, consider the housing bubble that existed before the financial crisis. Housing prices became inflated, and when the bubble burst a sharp correction took place.
Similarly, financial securities that trade regularly, such as stocks, can become overvalued (and undervalued, for that matter) frequently. The key to shorting is identifying which securities may be overvalued, when they might decline, and at what price they could reach.
Of course, assets can stay overvalued for long periods of time, and quite possibly longer than a short seller can stay solvent. Assume that a trader anticipates companies in a certain sector could face strong industry headwinds six months from now, and he or she decides some of those stocks are short-sale candidates. However, the stock prices of those companies might not begin to reflect those future problems yet, and so the trader may have to wait to establish a short position.
In terms of how long to stay in a short position, traders may enter and exit a short sale on the same day, or they might remain in the position for several days or weeks, depending on the strategy and how the security is performing. Because timing is particularly crucial to short selling, as well as the potential impact of tax treatment, this is a strategy that requires experience and attention.
Even if you check the market frequently, it might be wise to place limit orders, trailing stops, and other market orders on your short sale to limit risk exposure or automatically lock in profits at a certain level.
A portfolio management tool
Shorting can be used in a strategy that calls for identifying winners and losers within a given industry or sector. For example, a trader might choose to go long a car maker in the auto industry that he or she expects to take market share, and, at the same time, go short another automaker that might weaken.
Shorting may also be used to hedge (i.e., reduce exposure to) existing long positions. Suppose an investor owns shares of XYZ Company and he or she expects it to weaken over the next couple months, but does not want to sell the stock. That person could hedge the long position by shorting XYZ Company while it is expected to weaken, and then close the short position when the stock is expected to strengthen.
The process of shorting a stock is relatively simple, yet this is not a strategy for inexperienced traders. Only knowledgeable, veteran investors who know the potential implications should consider shorting.