There are so many different ways to make money in the stock market. The most basic way with stock shares is to buy them low enough and then sell them at a higher price later.
Did you know that it’s possible to make money in the reverse? You can sell shares in the market at a higher price first and then buy them back at a lower price later. This is called short selling.
The concept of short selling had me confused at first. I’d only heard that it was something a lot of traders did when they anticipated a drop in stock prices. None of it made sense until I executed my first short sale.
My First Short
Many years ago, a certain company messed up royally and was getting a lot of bad press. Shareholders were selling in a panic and the share price was dropping in high volumes. I saw that the price was at around $76 and I believed it would go down more. I lined up my order to sell 600 shares at the current market price and I hit, “Short.”
After that, the price fell considerably. In the order box I clicked on, “Cover,” and I bought back 600 shares at the new market price of $74.75. That is a share price difference of $1.25. With 600 shares, I made $750, excluding commissions.
Broken down, it looks like this:
- I short sell 600 shares for $76 per share (600 x $76 = $45,600). By doing that, I’m borrowing the shares from my brokerage to sell in the market for that price;
- The share price falls;
- Then I buy back (or cover) 600 shares at the current price of $74.75 (600 x 74.75 = $44,850)
- At the end of my trade, those borrowed shares are returned to my broker. I get to keep the difference in the short sale for a profit of $750;
- $45,600 – $44,850 = $750.
Despite the order at which the transactions occurred, the concept of buying low (at $74.75) and selling higher (at $76) is still preserved.
The Downside of Short Selling
As great as it sounds to make money when share prices are heading down, short selling is a riskier practice. Here are some reasons to consider:
1.Many investors don’t short sell or even know what that is. This means you don’t always have the majority of the market on your side.
2. Shorting is made possible when your brokerage firm has the shares to loan you from its own inventory of stocks. These stocks are either from the firm’s own positions or from the positions of the firm’s clients. If your broker doesn’t have the shares to loan you, you cannot short sell the stock. You end up missing out.
3. The market is generally optimistic. This means the fear and panic don’t always last as long as you might hope to support your short sell. Price reversals can happen fast. You generally need to have a shorter time horizon for shorts and you need to be watching your positions more closely.
4. When you buy a stock in the standard fashion, the worst thing that can happen is that your share price drops to zero before you’re able to sell it. In this scenario, the most you can lose is the entire amount of your investment. When you short a stock, the share price can go up indefinitely — this means you can lose more than the entire amount of your original position. Potential unlimited losses is what makes shorting considered a high-risk practice.
5. Profits from short selling are normally taxed as income rather than as capital gains. This is not favourable taxation.
6. If the company that you’re short selling is paying out a dividend, you have to pay the dividends owing to your firm or to the client those shares are being borrowed from.
Why I Don’t Short Sell
The reasons above are enough to discourage me from shorting, though there are many more that I haven’t mentioned. Short selling is a more advanced way to make money in the stock market and is best left to the pros. I don’t short stocks anymore because I prefer to own them.
I normally don’t discuss short selling because it’s not for most people, not to mention it’s really confusing. I only feel like it’s relevant to discuss shorting in a market like the current one so that new investors can understand the additional reasons why the prices of their stocks might be going down so much. It’s not just from investors collecting profits or abandoning their stocks out of fear of losing more — it’s also from short sellers trying to profit.
After the short sellers have had their fun and after all the panic selling and pessimism have subsided, it usually takes a while for a stock to recover before going up again with more investor confidence. I’ve got my wish list of stocks to consider buying when all the selling is over, so I’m just waiting for good setups and a better market.
Alternatives to Short Selling
Even when the whole market is negative, I don’t always want to sell my stocks, nor do I short any stocks, as you already know. Sometimes to combat the downward funk, I will buy shares of inverse ETFs to make money in the interim.
Inverse ETFs are exchange-traded funds made up of more complex financial instruments that generate money when the market is moving down. Like a regular ETF, its movements mimic the market index ETF it is modelled after, however, it’s designed to go in the opposite direction. Basically, when the market index goes down, the inverse ETF goes up.
Index ETFs are often created in a way to move up to 3 times more than the index performance or up to 3 times less. These differences in performance can either enhance your trade or really hurt it when you’re wrong. You have to be careful and consider this when selecting ETFs.
I still regard buying an inverse ETF a very risky strategy as it’s still in theory ‘shorting’ the market. Also, inverse ETFs tend to have higher management fees because they consist of higher maintenance assets than most regular ETFs. Higher fees and MERs in funds diminish their value and overall returns. For this reason, I usually only buy and sell them for shorter-term swing trades.
Before investing in an inverse ETF or deciding to short sell anything, please consider the risks. At this point in time (it’s December 2018), I think the market will go up a bit more before it goes down again early in the new year. We’re so close to the year’s lowest trading levels of the US markets. I don’t think things will really start moving up again until we at least break below those 2018 levels first.
I know a lot of investors who have been feeling beat up and want to do something to save their portfolios. If you’ve been feeling this way for the last few months, the best thing to do at this point is to think of your future strategies for your portfolio and be ready for them once the market is more positive.
Remember that downswings and bear markets are a normal part of the cycle for stocks – nothing goes only in one direction forever. Going short now after the market has gone down so much is not only is riskier, the returns won’t be as great had you gone short in early fall.