Stocks don’t move in a single direction and if you have enough reason to believe that share prices are about to go down, then there are ways to profit from betting against them. However, betting against stocks is much trickier compared to going long and there are several factors to consider before you short.
1. Check with your broker first
Shorting means that you are “borrowing” the asset first, with the promise to buy it back at a later date. When you short a stock, you usually “borrow” it from your broker, wait for the price to drop, and then buy it back to cover at those cheaper levels. With that said, you have to verify if your broker does allow this practice or look for one that does.
You need a margin account with your broker in order to be able to short shares. This way you can go short with just a few clicks, similar to how you would buy stocks. Also, you have to ensure that your broker can get enough shares for you to be able to short. If they don’t, then there’s also the option of looking at CFD brokers or spread betting firms and betting on a downward price move.
2. Do your research
Why are you shorting the stock in the first place? Do you have enough fundamental reason to believe that the decline will happen? And is this based on reliable analysis or company information?
When it comes to stocks, market information is crucial in order to understand what’s behind a move. But sometimes that information can be hard to come by. That’s why you often need to put in a lot more investigative work to find out what is moving price, much more so than with more popular assets like futures. Some reasons that could lead to stock price declines are impending bankruptcy proceedings, share dilution or negative earnings or news surprises.
3. Time your entries with technicals
Fundamentals comprise only half of the equation and technicals can come in handy in helping you pinpoint where exactly to short. These can comprise indicators, inflection points, short float or volume information that can help you determine if investor interest is picking up or if a huge reversal is about to take place. Technicals also come in handy in letting you decide when to book profits off your short trade. Generally, I will never go short into a company that is already in oversold territory as the potential for a short squeeze is too great.
4. Don’t forget dividends
When you are long on a particular stock that pays dividends, you enjoy those extra returns on your holdings. Conversely, when you are short on a stock that pays dividends, you also have to pay those liabilities yourself and this can impact your bottom line, profit or loss. This is another reason why short trades are better held only for a short amount of time.
5. Consider put options
Another way to bet against a stock is to buy put options. A put option gives its holder the right but not the obligation to sell the underlying stock at a specified price at a certain time. To have this option, you also have to pay a premium to the seller of the put option.
To illustrate, consider buying a put option to sell stock XYZ at $40 in a month at a $1 premium for the contract. If the stock price drops to $30 then, you can exercise the put option for a profit of $9, which is the strike price of $40 minus the current price of $30 and the $1 premium. If the stock price goes against your forecast and rallies to $50, your option expires and you are left with a loss of $1 in premium paid.
This method is often preferred by more advanced traders since it does ensure a smaller potential loss limited to the premium paid. Another good strategy is to use call options as a potential hedge for your short position. This is often placed on similar stocks, perhaps in the same sector or even with index ETFs. For example, you might short Microsoft and buy a call option in Apple as a hedge.
Alternatively, if you want to short stocks more generally, you can buy volatility ETFs – so long as you know the risk associated with these products.
6. Look at inverse ETFs
One more way to bet against stocks without shorting the actual asset is to trade inverse ETFs, which are considered simpler compared to put options. These don’t involve individual stocks but rather a group of assets, a specific market, or an index that can diversify your risk. These can be also used as hedges against existing long positions.
7. Be mindful of the “short squeeze”
A “short squeeze” happens when a stock undergoes significantly heavy short interest with no counterparty that is willing to take the opposite position, thereby weighing on market liquidity. A small move higher could lead sellers to react quickly and cover their existing positions, consequently fueling a more rapid rise in stock prices.
8. Fear is more powerful than greed
It is often said that price declines occur more rapidly compared to rallies because fear is more powerful than greed. In other words, pessimism can trigger a larger and sharper market reaction compared to optimism, which means that selloffs can be quick and that shorting can require a shorter-term perspective.
9. Long-term direction of stock market is up
At the end of the day, the bigger picture take on stock markets is that they could continue to increase in value so the longer-term direction is to the upside. It can be more challenging to pick market tops than bottoms, as investors are always keen to buy on dips. Still, this doesn’t stop companies from going bankrupt or from undergoing periods of falling profits, which means that there are plenty of opportunities to catch market drops.
One thing to bear in mind is that stock market indexes like the S&P 500 are weighted by market cap, meaning the largest and best performing stocks typically account for most of the movement. This means that looking at the long-term picture of stocks is slightly biased towards those stocks that have done well and fails to represent the many short opportunities that are available.
10. Manage your risk
There are no guarantees in the markets and even with the best kind of analysis, there’s always a chance that an event or announcement can cause price to move against you. This is especially true in the realm of small cap stocks where manipulation and lack of liquidity can cause extended price moves.
Whether you’re going long or shorting a stock, be it through margin or other products like options, ETFs, or CFDs, it’s always important to practice proper risk management to ensure that your trading account won’t get wiped out on a sudden reversal or pickup in volatility.
At the end of the day, shorting stocks is a dangerous activity because it is based on margin which means you can lose more than you put down. Liquidity is a major component of any short selling strategy because the less liquid a stock is, the more it can gap up overnight and past your stop causing heavy losses. This makes shorting a careful balance. I never bet more than 10% of my account on a short position and am always careful about holding trades overnight.
So don’t forget to calculate your position sizes depending on your risk tolerance and the liquidity of the stock, making sure that stop losses are in place to limit your potential losses in case the stock price doesn’t move in your favor. And when it does, it can be helpful to lock in profits along the way.
Thank You For Reading
Joe Marwood is an independent trader and the founder of Decoding Markets. He worked as a professional futures trader and has a passion for investing and building mechanical trading strategies. If you are interested in more quantitative trading strategies, investing ideas and tutorials make sure to check out our program Marwood Research.
This post expresses the opinions of the writer and is for information, entertainment purposes only. Joe Marwood is not a registered financial advisor or certified analyst. The reader agrees to assume all risk resulting from the application of any of the information provided. Past performance is not a reliable indicator of future returns and financial trading is full of risk. Please read the Full disclaimer.