A Primer on Shorting

I have never shorted a stock before, but in this market environment, I feel like I am missing out because of my hesitation to short. What are the important things to keep in mind when shorting? Thanks. Love Your Site, Rachael.

Thanks for the great (and timely) question, Rachael. I'm sure you have noticed that our "in play" list has become heavy on the short side lately. This is just a factor of the market that we are experiencing. We, as traders, don't try to anticipate the market; we just react to what it is telling us. For the past few weeks, the risk/reward ratio that we always consider before entering a trade has been leaning towards the short side. This is not to say that shorting stocks in an environment like this is "safer". Au contraire. Shorting is generally much more risky. Let me explain why and also touch on some things to consider when shorting stocks.

First, you cannot short a stock on a downtick, meaning a stock has to momentarily stop dropping and register an incremental gain before you can sell short. Second, the short side is inefficient -- there are more long traders than short traders. Third, you can't short stocks within an IRA account or a UTMA/UGMA (child's) account. This is because your trading account must be set up on margin, meaning you have the capability to borrow from your broker. This brings us to the fourth and most important point. When you short a stock you are on margin. You have borrowed stock to sell from your broker that you don't own. The whole time that you are short a stock, you must cover any dividend payments. This comes into play when the stock goes against you. Not only do you lose the principal on your trade (the difference between where you sold and where you bought back) but you are also out the cash you had to fork over for the dividend. In extreme cases, if the trade goes against you enough, your broker will buy back the stock without your permission to cover the trade.

All this sounds harrowing if you have never shorted a stock, and it can be scary. But, in this market, it may be worthwhile to short for the more risk-oriented trader. If you are just such a trader, make sure that you have a buy stop in place (religiously) and be aware that when a stock starts going up (against you) it can feel like it will never stop running. Stocks can turn on a dime and never look back. Bottom line: in down markets, flip the chart upside-down and look for the same breakout patterns that telegraph a long trade. As the old saying goes, "It's easier to fall out of a tree than climb up it."

Good Luck and Have a Good Trading Day

Craig Seidler
Assistant Editor