People with extra income that exceeds their needs often want their money to work for them to generate greater returns and this is why they choose to invest. Money can generate compound interest over time and this can lead to a healthy return if the stock market is doing well.
But, not all market wealth comes from the buy low and sell high ordering decisions. In some cases, the exact opposite philosophy is used, this selling high and buying low strategy is known as short selling stocks.
This is a risky approach. As an investor, you’re betting on the stock of a company dropping instead of rising.
A short sale is bound by two options, they are finite gains where the stock can only fall to $0 and infinite losses where the stock price can rise endlessly.
Certain investing platforms allow short selling on stocks, index funds, bonds, and other assets, and some do not support short selling. In this article, we’ll explore this topic in more detail to ascertain if the rewards and increased risks are acceptable for you to grow your portfolio.
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When an investor short sells or “shorts” a stock or other assets, they are making a bet that that specific asset price will decline. Short selling requires a margin account to open a position by borrowing shares of a different stock or asset which the investor believes will decrease in value by a certain expiration date. This date is when that asset is returned to the original lender for the specified borrowed amount.
The investor pays interest on the borrowed asset which acts as compensation for the lender. The investor can execute the trade by selling a borrowed share at the market price to any other investors that want to pay that price. The investor then has the obligation to return the shares to the lender by the agreed expiration date, but they hope to repurchase the same amount of shares at a lower value when they’re returned.
This may sound complex, but essentially, the investor has made a bet that the price of the asset will decline and they can repurchase the asset at a lower price. When the asset has been repurchased for less, the investor can return the same amount to the lender for less value and the difference is the profit margin.
Let’s take a look at a short selling example in more detail:
A trader believes that stock A, which is currently traded at $100, will decline in price during the next two months. This determination has been made with investment research software and considerable trading experience.
The trader borrows 100 shares of stock A from a broker and then sells them to a different investor for $10,000 (100 shares x $100 per share = $10,000). The trader has just shorted 100 shares of stock A because they sold stock that they have borrowed and not purchased. This shorting occurred because the shares were borrowed from the trader and this may not be possible if many traders are trying to heavily short the same stock. The availability of the shares required to borrow and sell short may be limited if demand is high.
Let’s say that a month has passed, the company has reported poor financial results that are below market expectations and stock A has declined to $80 per share which is a decline of 20%. The trader wants to “close the short position” at this time and they purchase 100 shares of stock A at the current $80 per share price which is a total cost of $8,000. They then return their borrowed shares to the broker and they just made a profit of $2,000 on that short sale. This profit excludes any interest payments on the margin account and the commissions.
This sounds great, but there’s a catch. If the trader had made a bad prediction and the company had reported better than anticipated results with a share price increase of 20% they would have lost money on that position. In this case they would have lost $2,000 ($100 per share up to $120 per share is a loss of $20 per share x 100 = $2,000 loss).
As you can see, short selling has a return asymmetry, the short seller can only ever earn a finite gain if the stock can only decline to $0. It’s clear to see that shorting is extremely speculative and the risk of a loss is infinite because any asset could in theory increase to infinity. As such, short selling should only be attempted by seasoned investors that can weather the potential financial pitfalls.
Webull allows short selling on their platform, but there are certain requirements that traders must meet and restrictions that they must adhere to before they can short a stock. A Webull trader must have a Webull margin account and the net account value must be maintained at $2,000 or higher. It’s possible to inverse ETFs to capture value based upon the decline of the asset price and there are various options and strategies to explore.
For more details, read our Webull review.
How to Short a Stock on Webull
Webull currently offers new users up to 12 free stocks for trying the platform. You’ll get two free stocks (each worth $3 – $3,000) for signing up. Deposit any amount to get up to 10 more free stocks. Sign up for Webull through this link to be eligible for the bonus.
If you meet the Webull shorting requirements, you can short your first stock on the Webull platform. The company will act as the intermediary when you borrow the shares from an investor to open a short position and then sell those borrowed shares at the current market price.
When you want to close a short position or you are compelled to due to a margin call, then Webull will buy those shares back and return them to the lender for you. When the short position has closed, you will net the difference between the initial shorting price and the repurchasing market price. If you sell at a higher price than you purchased those shares, the difference less any incidentals will be the profit. If you sell for less, then you will realize a loss.
Here are the ten steps (in order) that you need to follow when you short sell with Webull. They are:
- On the main Webull screen open the “Watchlist” tab.
- Look up the stock and tap on it to select it.
- Verify when a purple arrow icon appears at the top right of the stock page.
- When the icon appears you can short sell.
- At the bottom left tap the “Trade” button.
- The order direction should be selected as “Self”.
- On the order submission screen, fill out the required fields.
- Submit the sell order and it will be filled automatically.
- When the order fills, press the “Home” tab to see the order executed.
- In the “Position” section you will see the short position expressed as a negative quantity.
When you short stock on the Webull platform, you’re borrowing the shares of a specific company’s stock before they can be sold. So, the associated costs on Webull will be the borrowing fee that you paid for that stock in the margin account. This margin loan rate on borrowed stock can vary on a daily basis depending on the prevailing conditions in the market. The margin interest is how Webull earns money. The shorting fee is calculated on a daily basis and then charged each month using the following formula:
The Daily Margin Interest (or Short Position) = The Daily Market Value of Borrowed Stock@ Market Close x Stock Loan Rate for That Stock / 360 days.
The Advantages of Short Selling
There are two main advantages of a short selling strategy:
When the prices are trending downwards and investors are cautious, this is referred to as a bear market. Holding stocks or conducting day trading is risky because even slight price improvements lead to drastic price falls in a bear market. One of the ways to make money in a bear market is to short sell assets, and if your predictions are correct, you can make a lot of money in extremely negative market conditions.
If you hedge an investment, you’re offsetting or minimizing the chance that the investment will lose value. Some professional traders will use shorting to offset any temporary losses that they may incur if they have made a bad investment. This will allow them a chance to earn some lost money back when a dip in value has occurred with no need to close their positions.
Let’s take a look at a detailed example of this strategy:
Let’s say that you have purchased some Company A stock because they have a good financial foundation and they’re selling a great product. But, some political event or scandal causes Company A’s stock price to drop dramatically. You may still think Company A is a great prospect in the medium to long-term but each day its stock value is dropping and it may continue to drop for some time. This is when you may consider hedging your position with a short sale of Company A stock. You can regain a little capital until the situation stabilizes with no need to sell your initial investment in Company A.
Although there’s considerable potential for profit, and with Webull a low barrier of entry, you may wonder why many traders don’t short sell stocks even if the market is trending downward. There are two considerable risks inherent in shorting:
1. There’s No Limit on Loss
If this sounds daunting, you’re paying attention. With a traditional stock investment, the worst possible scenario is that you lose 100% of your investment. Let’s say you buy 100 shares at $10 each, the most money you could lose would be $1,000 if the company went bankrupt and the stock went down to $0 value.
But, if you short a stock, there’s no limit to what you can lose. If a price surge occurs, it’s possible to lose hundreds of thousands of dollars in a few days! Many brokers would require you to close out of a position before this level of loss occurs. But, shorting is very risky and a single bad call can lead to financial ruin and bankruptcy.
When shorting, it’s possible for an investor to make a fast profit. But if too many investors are short selling, it can cause a normal price fluctuation into a full-blown collapse.
When investors are betting on a stock dropping, it can create an artificial sell-off and the value of the company or asset is deflated beyond any natural point. S
ome financial experts blame shorting for the 2008 financial crisis because short sale orders panicked Lehman Brothers Holdings. As the sellers rushed to dump their shares, it caused the price to plummet and the situation only got worse from that point on. Of course, there were other factors in play during the crisis, but placing too many bets against the market will suppress share prices and encourage large-scale sell-offs.
If you’re still set on the idea of short selling a stock, there are four steps you need to follow to maximize your chances of success and mitigate the considerable risks.
Short selling is extremely risky, you can gain and lose thousands of dollars quickly. So, before you consider entering a short position it’s important to conduct thorough research on a wide variety of stocks to ensure that you’re choosing the correct one to short. Most traders will use two forms of analysis to decide if they should short sell a stock, they are fundamental and technical analysis.
Fundamental analysis will measure the stock value based on the financial management history, the overall condition, the board of directors, the economy as a whole, and other factors.
Technical analysis will not involve any attempt to quantify the intrinsic value of an asset. This approach evaluates a stock using charting patterns to track the price changes of an asset. Certain candlesticks or pattern formations can indicate that an asset can decrease in value in the short term.
As a starting point, stick to researching stocks in an industry that you understand fully. If you think that you’ve found a stock that could decrease in value in the near future, it’s time to move on to step 2.
We covered this earlier in the section titled “How to Short a Stock on Webull” and the process is pretty simple if you follow the ten steps in order.
When the short has been set and you have the position, it’s important to monitor the stock price that you’ve chosen. If your research is correct, it may decrease in value. And if it starts to increase, you need to close out to limit your losses.
When the shorted stock price has fallen to the desired levels, simply enter a buy order for the number of shares of that stock that you owe. Many brokers have a “Buy to Cover” option on their brokerage ticket, which means that you’re purchasing back stock to close out your position.
When the buy to cover order has been filled, the short selling is completed. If you have money left over after the interest payments and the broker’s commission, that’s your profit. This should be displayed as cash in your brokerage account and you can move on to your next trade.
Short selling stocks with Webull or any other platform that allows shorting can be a useful strategy in certain market conditions. There’s considerable potential to make money fast, and it’s one of the best ways to make a profit in a bear market. However, shorting is extremely risky and you can lose an unlimited amount of money in a very short period of time. Shorting is not recommended for new traders and inexperienced investors or those that cannot afford to lose money.