Short sellers don't need to panic!

How To Short Stocks: Tips & Strategies

June 15 by Jitan Solanki

It’s a sad truth that most people don’t know how to short stocks. They’re missing out on a huge opportunity. Most of the crowd only know how to buy a stock and why they should do it. After all, when you buy a stock you are buying a share in the company’s profits. We all know most companies are driven by that greed to make more profits. When the stock price goes up, that makes it a win-win all round.

The board of directors are happy as they can buy that extra yacht; the company executive is happy as they can pay off their third wife’s divorce; the shareholders are happy as they can sit back and watch their retirement pot grow; and, of course, the trader is happy as they had their finger on the buy button too. The good vibes keep flowing and everyone is ready to crack open the champagne…until it all goes the other way.

Traders beware!

Why Go Against The Herd And Short Stocks?

Simple. Every now and again, someone ends up being a little bit naughty. Maybe they fudged some accounting numbers or maybe they spent more time on the private jet than in private meetings and missed their sales targets. Suddenly, the stock price starts to fall. Hedge fund kings start to sniff out some weakness and are ready to pounce by going short.

The question is, does it pay for you to buck the trend? It may sound crazy but sometimes there can be rhyme and reason to do so. Just imagine if you kept trying to buy the dip in the 2008 crash and the 2000 tech bubble? Not good. You need to have something else in your armoury during these times. This is where shorting comes into play.

So, without further ado, let’s look at three scenarios when you may want to consider hitting the down arrow. Oh, it really is that simple to short stocks in the BUX app, by the way. Just tap the down arrow and you could profit from a falling stock price. Awesome, right?

 Shorting stocks doesn’t have to be painful!

Three Scenarios To Short Stocks

#1 When the s*it really hits the fan, like a financial crash

Arguably, the market spends more time going up than it does going down. After all, there have only been three significant stock market crashes in recent years. The 2000 tech bubble (OK, not that recent, I guess!) and the 2008 financial crash. (Incidentally, one of the top 6½ stock market crashes of all time.)

So, what’s the point of shorting a stock if a crash doesn’t happen that frequently? It’s a good question. The answer is because the market was in freefall for nearly a whole year before it recovered. That’s a long time not to be trading! Any movement is good movement when you’re a trader.

 Yea, that looks painful.

#2 When companies get caught with their pants down

This happens more times than you think! Remember the 2008 Royal Bank of Scotland scandal, the 2014 Tesco scandal and the 2015 Volkswagen diesel emission scandal?

There are always going to be some bad apples in a company who indulge in some questionable behaviour. When the company realises its employees have been doing something naughty, then it can either sweep it under the rug and let someone else deal with it in years to come, or release a press statement to their shareholders and the media.

In either scenario, investors will run to the hills and get out of their positions, causing the stock price to fall. Then you’ll get the big short players coming in, further pushing down the stock price. Take the UK’s biggest grocer, Tesco, for example. In 2014, the Tesco Chief Executive went on the wires to say he discovered an accounting scandal at the company. That’s right, they overstated their profits by £250 million in just six months!

Tesco’s stock price went from £3.70 all the way down to just £1.40 over the next two years. It even led Warren Buffett to bank a loss of $444 million in what he says was one of his only, yet biggest, mistakes. If you wanted to short stocks at that time, then Tesco was the one.

 It happens more than you think!

#3 When a company misses their earnings estimate

This is probably the most favoured strategy amongst those who want to short a stock. Why? Well, you can’t always bank on the fact a company will get caught with their pants down or a financial crash will happen. However, at the end of every quarter of the year, all public companies have to report their earnings. This provides huge opportunities for the savvy short sheller.

The theory is that most people are already positioned for the outcome. That’s because analysts give out their estimates on what the earnings report could be. When the actual result is different, it catches some people off guard. When the actual results in the company’s earnings report are coming in lower than the analyst estimates, then it’s usually the kiss of death for the share price. Some investors will get out of their long positions, causing the stock price to fall, and some traders will tap the down arrow to short the stock as it falls.

Now, a one-off earnings miss may see the stock price recover quite quickly. However, if a trend of missed earnings estimates starts to develop, then bye-bye daisy. This could be the beginning of a sinking ship with major short sellers providing no life jackets whatsoever.

Hmm. Time to know the risks!

The Risks Of Shorting Stocks

Of course, we also need to acknowledge the risks of trading short stocks as well. It’s all about safe trading, folks!

One of the major risks of being short stocks is that you can get caught in something called a ‘short squeeze’. It’s not a game from the bedroom but it could end your trade pretty darn quick. When everyone is shorting a stock, it becomes a lot more sensitive to any type of good news announcement. That’s because in that scenario, everyone wants to get out of their trades quickly, resulting in a sharp move higher. Check out Joe Campbell who got caught in this trap and lost all his money and actually ended up owing the broker! Of course that doesn’t happen with BUX with the awesome Auto-Close feature. 

Another important fact to know is that some stocks may not be available for you to short. That’s because the boffs at the SEC (Securities & Exchange Commission) put in something called a ‘circuit breaker’ if a stock falls more than 10% from its previous day’s close. They call it Rule 201. In this scenario, no one will be allowed to take a new short position at that price, or lower, for the remainder of the day and sometimes into the following day as well.  

So there you have it, folks! Now, check out the 6½ most shorted stocks.

Written by

Jitan Solanki

A self-certified trading junkie, he's not your typical heavy metal drummer and international traveller. But he loves to share his ideas and passion to all, no matter where he is in the world. He has a lot to share with over ten years experience trading stocks, commodities and foreign exchange. Connect with him on BUX: jitans

Disclaimer: All views, opinions or analysis expressed in articles are that of the author and do not represent the views of BUX. Neither BUX nor the author provide financial advice and these articles should not be construed as such.

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