Shorting a stock involves selling borrowed shares, buying them back at a later date, and returning them to the borrower.
The reason for shorting a stock would be you think a company's shares are headed down. A successful short seller will make a profit if they are able to buy back the borrowed shares at a price lower than what they initially sold it.
There are always short-selling candidates in the market, even when the Dow is going higher. You can be ready to profit with this step-by-step guide to shorting a stock...
Shorting a Stock Step No. 1: Identify a Short Candidate
Before approaching a broker about a short sale, you'll want to do your due diligence.
There are a number of research firms devoted primarily to finding short candidates, such as Citron Research and Muddy Waters LLC. Companies like these conduct "forensic analysis," Money Morning Capital Wave Strategist Gilani said, often with a team of researchers sifting through company documents to identify any factors that could suggest the company is overvalued.
Sometimes it can be as simple as finding a company that's involved in a costly situation, like battling litigation. Over the last couple years, Pershing Square Capital Management LLC founder Bill Ackman has had a well-publicized short position in Herbalife Ltd. (NYSE: HLF), the diet shake vendor he accused of running a pyramid scheme.
Our own Gilani recommended shorting ITT Educational Services Inc. (NYSE: ESI) after its stock soared in the beginning of 2014 despite a barrage of federal inquiries into "for-profit" colleges for deceptive marketing practices. Investors who followed his recommendation - which utilized a put option strategy as opposed to a pure short selling strategy -saw a 345.5% gain in 5 months.
Shorting a Stock Step 2: Put in a Short Order with a Broker
The reality of shorting a stock is a little more complicated than finding a company, watching its stock fall, and then pocketing your gains.
Because you don't outright own stock in the company you're shorting, you can't really sell the stock. Short selling requires that you borrow and return the shares. And that requires that you trade in a margin account.
You can't sell a stock in a margin account if there is not another trader willing to buy a stock on margin. If the broker can't find a counterparty to your margin trade for any reason - the market isn't liquid enough or there are already too many short sellers on a particular stock, for example - then you will not be able to short the stock.
But let's say you wanted to short ESI stock and your broker found someone going long on the other end.
Here's what happens next...
Shorting a Stock Step 3: Execute and Manage Position
Let's rewind to late January 2014. ESI stock is trading at $45.40 and has just experienced a 35% gain to open the year.
You see that's overpriced, so you put in an order and your broker finds a counterparty.
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You now would have an open short position on ESI.
When trading on margin, your broker will require you put up a percentage of the market value of the trade. That means you aren't required to put up the full value of the trade, but you are required to keep your position within a percentage of the value, and you'll have to feed money into that position should prices move against you.
Let’s say this so-called "maintenance margin" is 25%.
After a trading day ends, the long buyer on the opposite end of the trade has their account marked-to-market. Their account will have to reflect 25% of the value of the stock.
Returning to this example, at 25% of $45.40, both you and the long buyer would put up $11.35 to the account. If the stock rose to $50 on the day, the long buyer's account will have to be valued at $12.50 to mark it to market at 25% the value of the stock. That $1.15 will be debited from your account as the short seller, and credited to the long buyer's.
On the opposite side, if it falls to $40, the long buyer's account will be marked down to $10. That $1.35 will be credited to your short selling account.
Shorting a Stock Step 4: Take Profits (or Losses) on a Short Trade
This back-and-forth in the margin accounts will go on for as long as the positions are held. If a short seller is wary of a jump in the stock price and wants to get out for fear of losing more money, they'll buy back the shares they borrowed at market price and cover their position.
Sometimes stocks that are heavily shorted will get an extra pop at the end of a rally because if the price does creep up, it could scare the short sellers and flood the stock with even more buyers looking to close out a short position in what is called a "short squeeze."
But let's go back to the ESI stock example. If you had held the short position to yesterday's close (Thursday), you would have made a killing. ESI stock closed at $2.36 yesterday, meaning that since late January 2014, the stock has fallen 95%.
So how much would you have made on this example?
At $2.36 mark-to-market, the long buyers account would be worth $0.59. That means that drop from $11.30 to $0.59 - $10.76 - would be credited to your account which would now stand at $22.11 - a 95% gain on a stock that fell 95%.
Not bad.
More on Short Selling: The conventional approach to trading is to buy low and sell high, but what the conventional approach doesn't account for is that there are two sides to every trade. Wall Street has made quadruple-digit gains by taking the other side of the trade and Money Morning Members can learn how, too, with The Absolute Beginner's Guide to Short Selling...