What is Short Selling?

Short Selling is a way for individual investors and traders to take advantage of declining stock prices to produce profitable trades.

In a typical "Long Position", we buy a stock first with the intention of selling it at some point in the future at a higher price to produce a profit. Take a look at the chart below for a profitable "Long" position example using SWHC:


Now let's move on to "Short Selling". When placing a "Short Selling" trade, the order process is simply reversed. Meaning that we place an order to "Sell" first to open the position, and "Buy" second to close the position.

Here is a chart showing the order process for a profitable Short Selling trade:


Some of the terms you will see commonly being used in a Short Selling transaction are: "Short", "Sell Short" or "Sell to Open" for the first opening trade, and "Cover", "Buy to Cover" or "Buy to Close" for the closing trade.

As we have all seen over the course of 2008, there can be many reasons to consider "Short Selling". Some of them would be:

1. Lowered earnings guidance
2. Company earnings miss
3. Declining Sales
4. Poor Management
5. Management changes
6. Scandal
7. Product removal from market
8. Lack of new products
9. Large loss writedowns

You get the picture. Basically anything that you feel may have a negative short or long term effect on a stock price may be worth taking a closer look at for a Short Selling opportunity.

Typically, if you do your research well and are able to get into a Short Selling trade at the right time, you will be able to grab some quick profits. You'll notice that a stocks price declines much faster than it normally rises. This is due to fear having a strong emotional impact on people, causing them to panic and sell.

Take a look at the chart below and notice the time it took for the rise from the low to the high, and then look at the short time it took to erase all of those previous gains:



To be able to start "Short Selling" you will have to have "Margin" approval on your brokerage trading account. This is required because when you sell short a stock to first open your position, you are selling something that you do not own yet. At Wall Street Survivor, every account comes with $100,000 of margin already approved.

In order for your Broker to let you sell something that you do not own, they will have to trust that you will eventually "Buy to Cover" what you have sold. They do this by reviewing your account after you fill out the proper application, and providing credit to you through the issuance of "Margin" approval.

When you have Margin approval on your account, there are additional regulations that provide guidelines with this type of account. Some of them would be limits on how much money you can use on Margin, how often you can use the funds as well as limits to the amount of losses you can incur before they will eventually be allowed to liquidate your positions if needed to avoid further losses.

Make sure you read your Margin agreement and do some research to know what these rules are ahead of time. While the guidelines for a Margin account are there to protect you and the Broker, the last thing you want to happen is to incur large losses due to poor, or lack of proper risk management on your part, and having a position liquidated due to Margin regulations.

To see how to Sell Short stocks at Wall Street Survivor, see the Short Selling Stocks Video Tutorial.

Larry Both is a self taught stock trader with over 10 years of Active Trading experience. Using his experience as a small business owner and knowledge in accounting, economics and finance, he has placed thousands of trades during his career and has seen how different markets react in a wide variety of situations. He now provides information for stock traders through his website Online Stock Trading Guide.

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