5 expert tips for shorting a stock

You could say that when it comes to the world of stocks, shares, and investments, there are four kinds of people:

– Those who work in this sector

– Folk who have learned anything they do know from movie hits like Wall Street, or the closing section of the TV news when something major happens to make the figures go crazy.

– Folk who choose to passively invest in the stock market via a broker/advisor, balancing the amount of risk they feel comfortable with against the opportunity to make a lot of cash in a short time.

– Folk who take a greater interest, either making more active decisions about where to spend or invest their cash, or actually managing their own transactions and portfolio.

So when it comes to the amount of knowledge and insight you need when investing in stocks and shares you can assume the first group are doing fine, and that the second and third groups know as much as they need or want to. However, those who are either currently managing their own investments, or simply interested in learning more about how things work, these five expert tips on how to short a stock should be helpful.

In brief: what does ‘shorting a stock’ mean?

Shorting a stock, also known as stock shorting or short selling involves temporarily ‘borrowing’ a security – in this case stocks or shares, then selling the security to a third party with the plan that the price will fall and in a short time they can re-acquire the security with a profit on top.

Here’s a basic, small scale example:

Ms. X believes that a recent scandal which rocked Company A this week will reduce the value of the current $10 shares, so she ‘borrows’ $100 worth from her broker and acquires 10 shares which are short sold to the market. Shortly after the share value was reduced, in this case by 50%. Ms. X promptly purchases 10 shares at the new price of $50 total, and sends those back to the broker. Before interest and commission Ms. X has made $50 profit.

This makes stock shorting sound incredibly easy, but it’s not always so straightforward. There are some very real, very serious potential risks, so it may not be the best route for beginners to the market to pursue, but if you still keen to push ahead here’s some good advice from those who know exactly what they are doing when it comes to shorting stock.

Expert tip #1 Learn about short sale metrics

These are a pair of metrics which help track a stock’s activity.

Type 1 is known as Short Interest Ratio[SIR ], or as ‘short float’. This statistic measures the percentage of shares which are currently on the ‘shorting’ system in relation to the total amount available for purchase.

Type 2 is called the Short Interest to Volume, or ‘days to cover’ ratio. This measures the total number of shares in the short stock system divided by the volume of the stock in question which is being traded on average each day.

Traders use these metrics to better understand how investors in the current market feel about a particular stock. A bearish market means the prices of the stock are falling, while a bullish market delivers the opposite result.

Expert tip #2 Always have a generous financial float you can afford to lose

Any kind of wagering can only ever be truly successful if the investor can afford to walk away with nothing, but those who dabble in stock shorting need to be prepared to lose more than the initial investment made to buy (borrow) the stock in the first place. Traders use a margin account to fund sort stock transactions, which attracts interest while being used, and holds profits made on stock shorting trades.

Where the problem lies is that while potential profits on a deal are fairly easy to calculate, the very nature of selling short means a trader could be left with a loss which is bigger than the amount they ‘borrowed’. This can happen if the share price does not drop as expected, or if the trader decides to hold on for a further drop only to find they recover suddenly. In some cases the margin can be substantially wider.

Expert tip #3 Learn to spot the signs of a short squeeze

Successful short selling is all about timing, and traders who misread this can accidentally trigger a short squeeze situation. If short stock prices start to rise a trader must decide to buy back at a loss, or wait and risk a bigger loss. If enough traders start buying back early the market can lose confidence and cause the share price to drop further. Sometimes it is impossible to predict or avoid short squeezes, but traders must always be on alert.

Expert tip #4 – Avoid the dark side

Unfortunately, there are those who get involved with unsavory practices such as spreading false rumors about a company to undermine their standing and value. These people can damage the opportunities for genuine short sellers who use skill and research techniques to work the market – staying firmly within the parameters of stock exchange law and ethics.

Of course, some people will short a stock for other reasons — to hedge or offset a long position, for instance. (The various reasons for shorting were covered in a recent column on short interest, which represents the total number of shares that have been sold short and not yet repurchased.)

Short-sellers can indeed have a negative impact on a stock. Some short-sellers do disseminate negative information about companies over the Internet or elsewhere. Just read the message boards out there. But others are just trying to do what every investor wants to do: make money. They just take the mantra, buy low and sell high, and reverse it, sell high and buy low.

Expert tip #5 – Learn from the experts

It can take a long time to become really skilled and consistently successful at shorting stock, but there are always lots of good sources of inspiration and information out there for you to read and learn from. Click Here for more on this topic.

Shorting stock is a skilled activity which takes resources, a clear head, self-belief and in-depth knowledge of the market. It’s also a fascinating activity, and one which can be very lucrative. There’s never a ceiling on learning in this sector, so take every opportunity around to build your knowledge alongside your hands-on experience.

Melissa Thompson
Melissa Thompson writes about a wide range of topics, revealing interesting things we didn't know before. She is a freelance USA Today producer, and a Technorati contributor.