Investing in the stock market has been around for hundreds of years, if not more. Throughout history, investors and traders have embarked on a never-ending journey to uncover trading and investing strategies that provide them with a necessary edge to profit from various types of market conditions on a consistent basis. Regardless of the expertise of a trader, all traders are prone to extremely volatile markets and would most of the time be on the wrong side of the trade when markets are volatile. Bear markets are seen as very risky markets for any type of trader, which requires a different set of strategies to stay profitable. In a bear market, one of the primary trading strategies used by traders is shorting stocks; selling borrowed stocks from a broker in hopes the market price will fall dramatically, allowing traders to buy back the same stock at a lower price in the future and realize a profit from the trade. In this guide, we will take you through the process of shorting a stock and will discuss the fundamentals behind the process of shorting a stock.
Step 1 – Identify overvalued stocks
The first step is the exact opposite of the first step used when buying stocks. An investor who plans to invest money in stocks will first and foremost conduct a market research to determine stocks that are trading at undervalued levels. When shorting a stock, the first step is to scan the market to identify stocks that are perceived to be trading at a higher price than their intrinsic values.
There are a plethora of ways to determine whether a stock is overpriced. One of the most common screeners is to check the price to earnings multiple of a stock in comparison to the P/E multiples of peer companies and the industry average. A stock that trades at a significantly higher P/E multiple than the industry average or peer multiples requires a thorough investigation by a short seller to determine the underlying factors that have driven the stock price to rich valuation multiples. A common pitfall that should be avoided by short sellers is to categorize every stock that trades at high earnings multiples as overvalued. Sometimes, stocks are trading at high valuation multiples for fundamentally driven reasons, such as a pending merger or an expected earnings surprise.
Another strategy that could be used to research for overvalued stocks is to monitor and identify price movements that are a deviation from the economic realities. This is true for identifying undervalued stocks as well. A classic example is the taking Tesla private saga that triggered with the controversial Tweet by Elon Musk.
Elon Musk’s controversial Tweet
(Source – Twitter)
The day following this Tweet, Tesla share price shot up by more than 15%. However, a prudent trader who realized that it would be near impossible for Elon Musk and Co to take Tesla private at a steep price of $420 per share would have entered a short trade at around the day’s high of close to $380. Such a short seller would have realized a return of more than 28% within a month.
(Source – Yahoo Finance)
In addition to the above strategies, following macro-economic and geopolitical developments closely would unveil short selling opportunities to traders. Understandably, macro-economic and geopolitical developments are drivers of capital markets, whether it be higher or lower. Examples include monitoring trade tensions, interest rate decisions of policymakers, and geopolitical tensions between major players of commodity markets.
Step 2 – Borrowing stocks from the broker and immediately selling in the open market
The obvious next step is to borrow stocks of the overvalued company from the broker and immediately sell in the open market. If a trader is considering short-selling Tesla, the number of shares available for short-selling could be checked with the broker. Clients of Interactive Brokers can find the number of shares available to short on their website, while other brokers also provide access to these data.
At the current stock price of $235, a short seller who shorts 100 shares would immediately realize a cash amount of $23,500, assuming a hypothetical trade without any commissions. One factor that should be understood thoroughly is that the trader has an obligation to return back the 100 shares of Tesla to the broker, not the initial value of the trade.
Step 3 – Realize the profit or loss by buying shares and returning back to the broker
The 3rd and the final step is to monitor the price movement of Tesla after short selling the shares and eventually buy back the shares. If the stock price falls, say for example to $200 per share, the trader would have to invest just $20,000 to buy the required 100 shares of Tesla, which results in a profit of $3,500 assuming no commissions or interest. However, on the other hand, if the share price appreciates to $300 for example, the trader would have to invest $30,000 to buy back the 100 shares of Tesla, resulting in a loss of $6,500. In hindsight, a short seller expects the share price to decline to realize a profit from the trade.
Is short selling legal?
In many developed markets, short selling is legal. However, there are arguments for and against allowing traders to sell short stocks and realize a profit if the share price depreciates.
One of the most widely cited arguments that support the use of short selling is the fact that short selling necessarily establishes efficient markets by pushing undervalued stock prices higher and pulling overvalued stock prices lower. This is in line with the expectations of the Efficient Market Hypothesis. However, many investors and economists despise short selling as short sellers aggravate market downturns and pull markets deep into bear market territories. In essence, short sellers want companies to perform poorly so that their trades would end up making money.
During the financial crisis in 2009, short sellers came into the spotlight as these traders accelerated the pace at which banking stocks declined.
Regardless of the arguments cited against short selling, such practices are legal in many jurisdictions and as a trader, it’s very important to understand the basics of short selling as these strategies are essential to earn the best returns from the available information.
The Uptick Rule
While the objective of this guide is not to dig deep into the regulations involved in short selling, every trader should familiarize himself with the Uptick Rule. Implemented in 1934 by the Securities and Exchange Commission of the United States, the Uptick Rule says a trader could only short a stock if the stock price increased relative to the previous price. In summary, this rule requires traders to enter a short sell at a price higher than the current bid price, which is aimed at making markets more efficient and minimizes the potential impact of short selling in a panic-driven market.
Learning how to short sell a stock and when to short sell a stock is essential to generate profits in any market condition. However, many traders tend to view short selling as an illegal measure, which is not true. Renowned investors including George Soros have used short selling to generate significant profits, which is something every trader can replicate, with caution. As with any other trading strategy, the key is to understand the concepts involved in short selling thoroughly before executing any short trade.