When it comes to trading stocks, the most understood method goes like this – you buy a stock at low price and then over time, its price increases, and you sell it at a high price and take your profits. When you buy a stock and expect its price to go higher, it is referred to as going long on a stock.
When you buy or sell a stock, you go through a brokerage firm – the middle man between the buyer and the seller.
What is shorting or short selling?
As an example, let us say that Apple (AAPL) stock is currently trading at $100 and you believe that it is overpriced and you believe its price should come down to $80 within the next 2 weeks or anytime frame of your choice.
Based on your knowledge / belief, you sell one AAPL share (owned by the brokerage firm) at $100.
Now you owe the brokerage firm one AAPL share.
As you expected, AAPL share price falls down to $80 within 2 weeks.
You buy one AAPL share at $80 and return the share to the broker.
You get to keep $20.
I used this as an example to show how shorting works. When you sell a stock owned by the brokerage firm with your expectation that the stock price is going to fall and you are going to buy it back at a lower price and return it to the broker, this is referred to as going short on a stock.
What is needed to short stocks?
Brokerage accounts come in two flavors – cash account and margin account. You would need a margin account in order to short individual stocks.
You must have thorough knowledge of what you are doing. Shorting stocks is extremely risky.
Interest and Fees
When you short stocks, you still need to pay trading commissions for selling and buying back stocks. In addition, you will also need to pay interest on the shares you shorted to the broker. Remember, you are borrowing the broker’s stock and selling it and hence you have to pay interest on that amount. The interest rate varies from brokerage firm to brokerage firm.
Understanding Risk of Going long vs. Going short
Going Long: Let us say you bought one share of a company XYZ at $20 hoping it will go higher. However, the company crashes and the stock price goes down to $0. You lost $20 and the commission you paid to purchase the stock. So the downside risk you have is losing all your investment when you go long on a stock.
Going Short: Let us say you sold one share of a company XYZ at $20 (by borrowing from broker) hoping it will go down. However, the company stock rockets up in price to $100. You will need to buy the share at $100 to return the share back to the broker. You invested $20 (by shorting aka borrowing a share from broker), however you lost $80. So the downside risk is you could lose significantly more than your investment of $20.
Okay, you say, all this is very complicated. I don’t want to have a margin account, short individual stocks, and be paying interest to the broker. Is there an easier way? I had the same question.
How to Short the DOW?
Instead of shorting individual stocks, you could short a whole group of stocks that make up the index like DOW Jones. You could short DOW by buying SDOW an exchange traded fund. SDOW basically targets 3 times inverse return of DOW Jones. For example if DOW falls 1%, then SDOW will target to go up by 3%.
You don’t need a margin account, you don’t need to pay any interest to the broker etc. You would buy SDOW at a low price (when DOW is high), and when DOW falls, SDOW will go higher, at which point you would sell and cash in.
You can short stocks that make up other indices like S&P 500 using SPXU. There is an ETF mechanism available to short pretty much most major indices.
As I mentioned, shorting is extremely risky, and you must know what you are doing. This post is written for educational purposes to explain how shorting works and must not be considered investment advice.