Shorting a Stock: A Step-By-Step Guide

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...