First of all, let me explain what "short selling" is. Short selling is a term used in equity trading when a trader believes that a stock is too expensive and he/she borrows it from a dealer(usually a broker) and sells it. Goal is to buy it back later at a cheaper price and return these shares back to the dealer. If successful, you hope to pocket the profit due to price difference.
Let’s take an example. You are following a stock XYZ trading at $50 and you believe that it is going to fall to $40. What you can do is to short sell some shares, let’s say 500. Remember you don’t really own any shares, so you’ll borrow them from your broker. When you execute this transaction, your broker will create a balance of –500 shares in your account and will add sale proceedings from the sale. So excluding trading cost, selling 500 shares at $50 will result in a balance of $25,000($50 *500 = $25,000) in your account. This transaction is defined as “SHORT SELLING”.
Once you have entered a trade, real game begins. Once you’ve sold a stock short, you have to return those shares to your broker. Let’s say that after two weeks, stock falls to $45 and you decide to close your short position. What you have to do is to execute a buy order for 500 share(cost = $45*500 =$22,500). After executing this order, those shares are automatically returned to your broker(remember you had a –500 shares balance in your account, so buying 500 shares will cancel out that balance). End result – you made $25,000 - $22,500 = $2,500.
If you take a cursory look, this transaction doesn’t look bad and you made a profit of 10% in just two weeks. But if you pay a little more attention to selling short, you will notice that it could have as easily gone the other way too. What would have happened if stock had gone to $60? What would you have done in that case? Let’s assume that you would have closed the position at $60. In that case, you would have paid $30,000($60*500) to buy this stock back and would have lost $5,000. This is a very simple example. Most of the time, people don’t want to admit that they have been wrong on a trade and continue to hold a short position, hoping for it to fall one day. That could end up being a disaster in the end. As you can tell, most profit you can make on a short is 100%(if stock goes to zero), but the potential for loss is unlimited. So you have to be very careful if you want to experiment “Short Selling”.
The most important rule of short selling that most people ignore is identifying “momentum move”. Never ever short a stock when it has just broken out of a trading range or new high. No matter how strongly you’re convinced that it is over priced. I will give you one really good example.
Amazon.com(Symbol – AMZN) is a online retailer and if you trade tech stocks, you probably know all about it.
AMZN broke out of its range($40-$45) after earning report and move to $63 in just two trading sessions. For some inexperience short sellers, this move was too much too quick and they jumped in between $61-63 range. This short trade felt good for next 5-7 trading days when stock stalled around $63. This should have been the first red flag for short sellers. If stock fails to move down after a big move up, you should bail. Also, volume was anemic on those down days, another sign that it is going through consolidation and can move up big again. Some smart shorts closed their positions with small gains or losses based on their entry points. However, some refused to admit that they were worng and stayed in. Next big move came in with breakout 2 when stock moved from $61 to $74 in three trading days. At this point, you would think that majority of short sellers were out, you're wrong. Short sellers who went short after $63 and closed their positions earlier jumped right back in. Their argument - If this stock was too expensive at $60, it is now way too expensive at $70. You can go to any stock message board and when short sellers are posting excessively on how expensive a stock is or how hard it is going to fall, that's your time to go long because there is a short squeeze coming. Anyway, new short sellers were trapped when stock moved again with breakout 3 and lost even more money.
What can you learn from this? First of all, let me tell you that smart short sellers do make money. Short selling would have been long extinct if nobody was making money selling short. Trick is to figure out the right entry point. Anything that goes up too fast is bound to come down but you only want to be on short side when it comes down. If you're interested in selling short, here are couple of important pointers for you.
First of all, watch the volume. If you see AMZN chart, you will notice that volume was at least twice the normal volume on every breakout. You never want to go short when a stock breaks out with heavy volume - no matter how expensive you think it is. You should also pay close attention to volume on down days after breakout. An anemic volume on a down day is a clear indication that it is consolidating and about to move up again. Some short sellers mistake these low-volume down days as "stall" and start to belive that the "Run" is over. If you have been run over by stocks while going short, go back and take a look at those charts and you would see a clear pattern that you either didn't see or elected to ignore.
But there is a bright side too. Rather than going short, if you would have gone long, you would have made lot of money. So even if you're a short seller, either wait or go long until you find a break to the downside and then ride it down with your short position. Never sell short unless you see a breakout to the down side.
How to find breakpoints on the downside is a topic for another post.
Happy Investing!
Amplidyne
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