Short Selling: 101

It might be the most wonderful time of the year for some, but this December has me feeling a little Grinch-y after grinding out just about $200 in profits over all of last week.

Despite starting the month with a healthy green streak and holding on to high expectations for another strong winter like last year, the market and I have just not managed to remain in sync. While this week is off to a better start, I’m still trading in hope of having one or two home run days before the year is out.

Rather than recap exactly how I’ve been colliding against the market, I thought I’d spend the last few weeks of the year talking a little about some alternative approaches to trading I and other day traders use to maximize returns and minimize loss. I’ll try to assess some of the pros and cons to each, but I’d encourage more in-depth research into each before experimenting with them, even in practice. There’s no use getting frustrated with something you don’t completely grasp.

I’m going to start with short selling, or simply shorting, which even most novice traders are aware of the principle underlying. A trader borrows shares of a stock to sell from their broker, then buys those shares back at, hopefully, a lower price. In essence, the trader is banking on a stock’s price falling in the period that they are borrowing the stock.

Of course, if the stock rises, the trader will have to cover their position by buying back the shares in a hurry or else suffer an even greater loss. This rush to cover a short position the primary risk of short selling.

In a heavily shorted stock or a stock that jumps several percentage points very quickly, more and more short sellers try to cover, which causes the price to rise even more in what’s referred to as a short squeeze. This is why some day traders keep an eye on stocks with a lot of short interest (the amount of a stock’s shares being shorted) since a jump in that stock’s price can lead to exponential gains as short sellers rush to cover.

Short selling, like the other approaches to trading I plan to cover in coming weeks, can be useful, and even highly profitable, when a trader understands how to best use them. Still, even beginner traders should familiarize themselves with the full spectrum of trading options in case they get into a rut with vanilla day trading.