Short selling is a skill that's crucial to learn for your investment success. Find out what you need to know about how to short sell.
While the stock market has been strong in recent years, it's no secret that not everyone is getting the chance to benefit from it. If you're new to selling and trading stocks, you might want to make a name for yourself to set yourself apart from the crowd. Learning how to short sell is a valuable skill for getting involved in stock trading.
Here are 6 things to know when you're thinking of shorting your stocks.
1. Short For the Right Reasons
Many people will try to short a stock based on its valuation. This is a serious fallacy because when you short a stock based on its valuation, you fail to see the complete picture.
A stock's price-to-earnings ratio isn't the best reason to short a stock. You could be overlooking its valuation of price-to-book or price-to-sales. There are other factors to measure the health of a stock by.
If you're going to short your stocks, don't sell based on simple valuation metrics. That won't tell you whether or not your stock is worth shorting. You could make a mistake that you won't be able to recover from quickly or easily.
2. High Prices Don't Mean Everything
When stocks have done the healthy work to become valuable, they're stable for a reason. While some stocks could reach the six-figure mark, you might feel like you should short them when they drop by a few thousand dollars. However, those stocks tend to keep climbing and get even pricier.
Seeing a stock climb high isn't a good reason to short it. It's actually a bad reason to short it. That's a healthy stock that isn't going to crumble when the going gets rough.
You might want to buy high and sell higher on huge name brand stocks, but it's never a good idea to short against these stocks. There are other traders who are going to keep the price steady or are invested in seeing it climb.
3. Don't Believe the Hype
While there are lots of stocks that run high just because they've gotten a lot of media attention, that doesn't mean they're unhealthy. Some of these stocks are perfectly healthy, despite the fact that their health seems based on hype. Just because a sock has attention doesn't mean it's not for a good reason.
When the fundamentals are built on rumor, that leaves a lot of potential investors feeling wary. However, you need to look at these stocks on a case by case basis. A huge leap in value doesn't mean there's another shoe to drop.
Sometimes it stays there.
Don't get involved in these rumor based stocks if you worry about getting your heart broken.
While many of them eventually drop, not all of them take a major tumble. You could end up selling while others stay along for the ride.
Imagine how many people lost their faith in Google in the 2000s who are kicking themselves now.
4. Thinly Traded Stocks are Bad Candidates
If you're going to short on your stock, make sure that it's heavily traded. If you stand to make a difference beyond more than 1% of the daily volume of a stock, you could turn out to be a sucker.
A stock with 100,000 shares shouldn't be shorted by more than 1,000 shares. For the kinds of stocks where this is a possibility, wait until it matures a little further.
Some people will stay far away from stocks that don't go on more than 500,000 shares daily.
When you can upset the balance that much, you might not get your money's worth.
When you're getting started, work on reducing your risks.
5. Watch Short Interest
Some stocks have a large short interest. Depending on when you invested and the size of the company, traders can block your exit. You want your exit to be unencumbered by other traders.
A good rule of thumb for this is to take the short interest and divide it by the daily volume. This will tell you how many days the stock will have to trade to get to the number of shares that you've sold short.
If it takes more than 4 days to cover your short selling, you're going to be treading into dangerous territory. Remember that your reputation is on the line and that other people will want to know that you make smart moves. You could seem like an angel of death if everywhere you go, you try to short the stocks on.
6. Industry Matters
When you're shorting stocks, you need to be aware of the industry you're dealing with. While one company's shares might be low, that might not be the full picture of the industry. Some companies will take time to warm up to a hot industry.
When the market, industry, and your stock all show weakness, that's the time to move into short territory. If you're looking at a stock and any of these three traits look strong, you're going to make a wrong move by selling short.
That's why so many brokers work in a specialized industry.
There are a lot of moving parts to consider when trading stocks in something like the auto industry. You need to keep an eye on steel prices and other component parts of the automobiles. You also need to keep an eye on fuel indexes because changes there will trickle over to the auto industry fast.
Learning How To Short Sell Takes Focus
When you're learning how to short sell, there are a lot of mistakes that you can make. Your best bet is to talk to someone who is also working in the industry to learn what you should do. Short selling stocks is like surgery, in you need to know when to cut and also when not to.
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