If you’ve been watching the recent news about GameStop, AMC and other famously shorted stocks, you might be curious about how you can get in on that kind of action.
Short selling is a high risk but potentially profitable form of trading that works best in volatile markets. Learn how to short sell successfully, and ensure you don’t risk more than you can afford to lose.
What is Short Selling?
Short selling is the investor’s version of betting against a stock. If you think a stock is significantly overpriced or you anticipate news that will cause a major decline, you can borrow shares of that stock to sell at the current high price. Then when the price drops, you buy back the shares at the lower price, return them to the lender and pocket the difference.
As an example, let’s look at the recent case of GameStop (NYSE: GME). The stock had been on a slow decline since late 2013, with prices dropping as low as $2.57 per share by 2020. After a flurry of activity spurred by the reddit group r/wallstreetbets in early 2021, the price skyrocketed to $483 per share.
As an investor looking for short sale candidates, this sudden increase in price without any basis in the company’s actual financials is a major red flag that the stock is overpriced. This makes it a prime candidate for a short position.
To short it, let’s say you borrow 100 shares of GME from your broker to sell at $483 in January, earning a total of $48,300 for the sale. By February, you buy back the stock at around $54 per share and return the shares back to your broker.
Your profit is the proceeds from the initial sale ($48,300) minus the cost to buy back the shares ($5,400) and any fees associated with the transaction. That’s roughly a $42,900 gain.
The risk with this investing strategy is that the price doesn’t drop. Once you open a short position, you are obligated to return those shares. You have to buy them back, even if the price ends up going above what you sold them for.
If you had bought GME at $54, expecting it to drop back down to its previous low of $2.57 (like many hedge funds anticipated earlier this year), you would have been forced to buy back shares at $483 and lost $42,900 instead of gaining it.
This is what the reddit investors were aiming to do to the hedge funds who were shorting GME. They were trying to inflate the price even further, forcing hedge funds to lose millions by buying back shares at significantly higher prices than they earned when opening their short positions.
Despite the risks, you can profit from short selling if you do your research and implement strategies to control your risk. Keep reading for a step-by-step guide to short selling.
Step 1: Open a Margin Account
Short selling involves selling stock you don’t own, which means you’ll need to borrow it from your broker. You can’t do that with a standard brokerage account. Instead you need what’s called a margin account.
A margin account is an account that is authorized to borrow stocks or funds. Brokers set specific requirements for opening a margin account and also place restrictions on your short selling activity. For Robinhood, a margin account requires a portfolio worth either $2,000 or 100% of the purchase price.
You also need to meet margin maintenance requirements. This differs from position to position but usually margin maintenance requires that you have 25% to 35% of the total value of the position in account equity. If you own $10,000 worth of Stock XYZ, a 25% maintenance would mean you need at least $2,500 in your Robinhood portfolio at all times.
If your portfolio falls below that maintenance level, Robinhood will issue a margin call, which just means you have to pay back the cash you borrowed. You can do that either by depositing cash into your account or by selling stock on Robinhood.
However, Robinhood’s margin account is only for certain kinds of options trading and for margin trading, where you borrow cash to buy a long position in stock. It doesn’t offer short selling, so you need to open a margin account with a brokerage that does offer it.
Brokers that do offer short selling usually have similar margin account requirements to Robinhood. Some might be more strict and require higher portfolio balances and maintenance levels, especially for short positions.
Step 2: Identify a Short Sale Candidate
Once you have a margin account with a broker that offers short selling, your next step is to open a short position. A good candidate for a short sale is a stock that’s experiencing a sudden and dramatic price increase that can’t be explained by any significant changes to its financials.
Here are some of the signs investors look for:
- A stock is rallying while the rest of the market is relatively flat or declining.
- A stock is trading above its average 52-week high
- Trading volume increased suddenly
- The slope of the incline is steep (the price is rising quickly)
- The increase can’t be explained by any recent news or positive changes to the company’s financial position
When identifying a candidate, you should have specific criteria in mind. For example, you might look for the price to be at least 15% above its 52-week high or for trading volume to increase by at least 30% within the last week.
By setting specific criteria, you can then use screening tools to quickly find stocks that meet your criteria. Then dig into the news and financials of each company to identify the most likely to decline.
Step 3: Define Your Exit Strategy
One of the biggest mistakes new investors make in both long and short positions is opening a position without having a clear and specific exit strategy. If you’re not buying and holding, you need to know exactly when you will get out of a position.
For short positions, that means identifying the exact price you will buy shares at to cover your short position. This should be based on your research into the price history and what you think the stock is actually worth.
To build some risk management into your exit strategy, use these tips:
- Set your exit price (the price you buy back the shares) a little higher than what you actually expect it to drop to. It’s better to exit early with 20% gain than risk holding too long and being forced to buy back at a higher price than you wanted.
- Put a buy-stop on your order. This is like a stop-loss on a buy order but reversed. If the price increases too much, a buy-stop can automatically trigger a buy so you can close your position and cut your losses before you lose too much.
- Follow news related to the stock closely so you’re ready to exit at a moment’s notice, before the news affects the price too much.
Step 4: Open a Short Position
After identifying a prime candidate for a short sale and deciding exactly when you’ll exit, you’re ready to open a short position. If you don’t own the shares, you will borrow them from your broker and immediately sell them at their current price.
If you do own the stock already, you can do what’s called “shorting against the box.” It’s a way of hedging your portfolio against an expected decline.
Instead of borrowing shares, you just sell the stock you own but think is going to decline. Then buy them back after the price falls. This allows you to profit off of the decline instead of just losing value.
Note that shorting against the box only makes sense if you think the decline is temporary. If you don’t think the stock is going to recover, it’s better to just sell and reinvest the cash somewhere else.
Step 5: Cover the Position
The final step in a short sale is to “cover” the position. This just means buying back the same number of shares you borrowed after the price (hopefully) decreases. Once you buy them, the broker will immediately take the shares and any fees.
After returning the stock, you get to keep any difference between the price you sold at and the price you bought shares back at. At this point, calculate your exact gains — or losses.
Robinhood is great for beginners and mobile traders, but if you’re interested in short selling, you need to look elsewhere. Robinhood doesn’t offer it.
You can still keep your Robinhood account to sell stock you already own, but the margin account on Robinhood is strictly for options or for margin trading.
Compare margin account requirements at different brokers to find one that suits your needs. Once you know where you want to move, it will take a couple weeks to transfer your stocks off Robinhood.
Start the search right away by comparing these Robinhood alternatives:
Open a Margin Account Today
Whether you’re looking to profit off of a volatile market or you just want to hedge against some anticipated losses by shorting against the box, open up a margin account with a broker who offers short selling.
Then you just need to develop your short candidate criteria and open up your first short position.