What Does Short Trading Stocks Mean?
Short trading stocks as already mentioned mean that the trader borrows an asset from an investor. How is that? The broker “owns” a big number of shares and stocks, but these stocks and shares actually belong to its clients - “the investors”. So every time you are borrowing an asset you are borrowing it from an individual investor. To make short trading stocks a bit more simple let’s take an example.
Imagine you hear that Apple had a very serious issue with its production on the next iPhone. You are 100% sure that the price will drop in the coming days as Apple shares more information about the incident. In any other scenario, this would be an immediate “sell order” from your side if you owned any of the stocks. However, in this case, you don’t own any Apple shares, but still want to make some money out of this incident.
Let’s say you borrow 10 shares from a fellow investor. The price per share is $100, so the total amount you gain from selling is $1000. For shorting stocks you need to wait a few days for the price to drop after the incident. Let’s say that the price dropped to $90. You then buy these stocks back and give them back to the lender. Without any fees, your payout is $100, but after paying fees, paying the lender and all overheads your payout is more likely to be around $70-80. This may seem pretty low, but you’ve pretty much gained 7-8% of your initial investment in a few days, which is quite substantial in today’s market.
When Should You Short-Sell Stocks?
Short selling is linked to a high-risk ratio and when the trader is shorting stocks he/she needs to be assured that the price of an asset isn’t going to increase. Stock short selling is not a viable strategy when the market is growing. However, it’s an amazing one when a crisis or some kind of market correction is expected. It doesn’t have to be an all-encompassing stock market crash similar to the 2008 crash or anything like that. But maybe some kind of correction in a particular industry.
Some traders have mentioned that short-selling is amazing during elections as well. If it’s looking like a landslide victory for one of the candidates, you can short-sell the company stocks you think will be negatively affected by his/her policies. These world events truly show the best stocks for short trading which then subsequently become a part of your strategy.
According to historic data in the US, a president’s third year is the strongest for the stock market while the fourth is the weakest and is characterized by the lowest returns and incomes. This means that traders who want to short stocks can buy these stocks somewhere at the end of the third year, and observe the market during the last year. It’s best to do this strategy if it’s the president’s second term, so you know for sure that his/her policies will be changed after the elections.
What Are the Best Stocks for Short Trading?
There is no specific company whose stocks are perfect for short-trading. If someone says that the company has the best short-trading stocks, this means that this company is a goner and soon is going to go bankrupt. If that’s the situation, then nobody wants to lend out their shares, they simply want to sell them and get out as fast as possible. In order for short trading to work, there needs to be somebody willing to lend the shares out and then buy them back. If the company is on the verge of bankruptcy this means there won’t be an investor who wants to invest his/her funds in the company.
But, not everything is doom and gloom. There are some companies that have seasonal growth, meaning they remain relatively flat for a few months, then grow rapidly during a specific quarter, and then just go back to normal. For example, you know that a company releases something new every year or every quarter. You know that the stock price leading up to it will grow due to anticipation. Depending on the success of the newly released product, it may be a good time to start short-trading. For example, if the release is successful, then it’s best to steer clear. But if it’s not going according to plan, then punching on the opportunity is recommended.
For example, remember the Samsung Galaxy Note 7 fiasco, when the phones would ignite seemingly out of the blue. Samsung was forced to recall all of the phones, returning money to customers and costing it dearly. This rocked the stock price to its core. These kinds of scenarios are like a pot of gold for most short traders.
Why Shorting Stocks Isn’t For You
Short trading is extremely risky. Why? Because you are pretty much in danger of having limitless losses. To make it more simple, let’s go back to the Apple stock example.
As already mentioned in the previous example you bought 10 shares at a price of $100 each. But it turned out that the Incident was actually just a small glitch and nothing serious. In fact, Apple fixes it in a day and continues the product updates. Instead of the price per share dropping to $90, it rises to $120. You still have to return these stocks, and waiting for the price to drop is going to cost you quite a lot paying the lender interest. So you buy the stocks at $120, costing you $1200 in total, and you now have to return it to the lender, bringing your losses to $200.
Had you not sold them at $120 a share, they could have risen even further, thus costing you more and more.
Short trading stocks are quite risky for beginner and inexperienced traders. Even for experienced traders sometimes short trading can be loss-heavy. And If you don’t buy the stocks back before the price grows too much, you’re potentially exposing yourself to unlimited losses of money you may not even have (therefore going into debt).