The standard approach to picking stocks is to try to guess which companies are going to increase in value over time. There’s an alternative approach you can take, however; it’s called “shorting” and it involves doing the exact opposite. Instead of betting on which companies are going to win, you’re trying to identify the ones that are going to lose.
Why Try to Pick Losers?
Shorting a stock is a means to make money when you feel certain that a company is going to lose value. It’s a particularly valuable technique in down (or “bear”) markets, when general confidence is low and stocks tend to be declining in value in an unusual way. They’re actually a big part of how hedge funds operate; the “hedge” in question is the use of a series of short positions as a counter to the longer positions in their portfolio.
Statistically speaking, shorting can be seen as a bit more risky than traditional investing as markets tend to trend upward more often than not, and since you’re effectively taking out a loan rather than holding the stock directly. It’s more than just a day trading scheme, however. Shorting serves an important market regulation function in keeping stocks from becoming too overvalued when an irrational “feeding frenzy” starts.
The process of due diligence in selecting stocks to short is really no different than in picking the ones you want to add to your long-term portfolio. So, for example, let’s say you were interested in investing in the solar power industry since that’s an area that has been expanding quickly in recent years and still has considerable growth potential. Scouring sites that cover news about solar, we learn that battery storage technology is making great strides and poised for a major breakthrough. If a specific company is about to introduce a revolutionary battery product, it might be a good time to short their direct competitors.
How Exactly Does Short Selling Work?
The basic concept is actually pretty simple:
- Instead of buying the stock you are interested in outright, you borrow shares of it from a broker, with the promise of replacing that same amount of shares later.
- You then immediately sell those shares at the current price.
- If everything works according to plan, the stock then drops in value.
- You then buy the shares back at the lower price and return them to the broker, pocketing the profit (minus fees and interest).
The Risks of Short Selling
Of course, the big risk here is that your expectations are wrong and the stock rises in value instead of falling. In this case, you are a bit more vulnerable than you would be if you were simply holding direct ownership of a declining stock. Since you’re borrowing the stock, you’ll have to pay interest on it over time, usually about 2%. Even if the stock does decline, it has to decline at a certain rate to keep up with your interest and any fees or it won’t be profitable.
Brokerages generally do not set a time limit for how long one can hold a short position, but they also usually have the freedom to demand the return of the shares at any time they choose. Naturally, they will call in the shares if the stock starts rising significantly from the shorted position value to protect their investment. This means you have less freedom to “ride it out” with a shorted position if things don’t go the way you expect, though it is relatively rare for a brokerage to actually do this (and will likely only happen if there is a very unusual and sharp increase in value).
It’s also important to know that not every stock is available for shorting. Usually, the smaller a company is, the more likely you will not be able to short their stock. This happens because smaller companies can be so negatively impacted by shorting that they will not be able to conduct enough business to recover from the loss in value it causes. The biggest regulation imposed in this area is the “alternative uptick rule“, which prevents further shorting of a stock that has dropped more than 10% in value in one day’s trading.
So What Is The “Short Ratio”?
If you look at major financial websites, you’ll often see a “short ratio” mentioned for each individual stock. The short ratio simply expresses the number of days it’s currently expected to take to cover all the short positions, but it also indirectly tells you the number of shares currently being shorted by investors as compared to the number of shares available overall.
How do you get the number of shares being shorted? It’s pretty easy — just multiply the current short ratio by the 30-day average daily volume of shares, a number also generally provided to you by the major financial sites.
Reading the short ratio to determine how a stock is going to move is a complicated topic that takes added knowledge about other circumstances the company in question is in. Generally speaking, however, you can use it as a quick gauge of investor sentiment towards a company. The most basic read is that a high short ratio often indicates general confidence in the stock is dropping. There are exceptions, however, and understanding those exceptions (and the circumstances they’re found in) is the key to successful short selling.
Eleanor Cole works as a personal finance consultant. She shares her wisdom online with her articles as well as participating on social media channels.