Selling short is a for investors who bet that a certain stock will be lower in the future. Basically, you sell a stock that you don’t own in the expectation that it will decline and you can buy (cover) it a lower price in the future. It’s just like buying low and selling high, except that you do it in reverse order.
These investors make money when stocks fall—investors who are “short” the market—and if you’re nimble enough, you can successfully join them. But selling short is not an enterprise to be undertaken lightly; it’s an easy way for amateurs to lose money!
So before you enter into this arena, consider the five commandments of selling short in the stock market:
1. Thou shalt sell short only in bear markets.
“The trend is your friend” is one of the most valuable of the scores of market truisms that I’ve internalized over the years.
For more than 10 years, the market’s trend was up, and anyone who bet against it (hedge funds, for example) suffered.
But a bear market suddenly, historically arrived along the coronavirus pandemic this March, and while stocks have bounced back remarkably (unsustainably?) well, a second retreat is possible. If and when it happens you can garner some good profits by selling short, by investing in sync with that downtrend.
For now, though, the bull market has resumed, which means you should not start selling your stocks. The biggest reason for shorting only in confirmed bear markets—and most people forget this—is that the real long-term trend of the market has been up for centuries, and will continue to be up as long as investors perceive that the U.S. economy is growing. Usually, this long upward trend helps investors, which is why holding index funds for decades is one decent investing strategy.
2. Thou shalt sell short only stocks that are trending down.
This rule, like the first, ensures that the odds are on your side when you short. Trends, once in place, tend to continue, so you want to be sure that the stock you’re shorting is already in a downtrend. Sure, it’s nice to dream about shorting a ridiculously overvalued stock at the top and riding it down, but picking tops (and bottoms) is a fool’s game. Put the odds in your favor and only sell stocks short that are in confirmed downtrends.
3. Thou shalt sell short only when public opinion of the company behind the stock has a long way to fall.
Stocks decline because investors as a whole lower their expectations about the stocks’ future—and when they do, some stop buying and others start selling. For little-known stocks, expectations can’t fall much because there aren’t many expectations. If anything, expectations are likely to rise as people discover the company and the stock.
It’s far better to short stocks that are over-owned, and stocks that are or were well loved, and which are thus ripe for lowered expectations. For example, Chipotle (CMG) after their food contamination incident. Chipotle stock has since completely recovered, reaching new all-time highs above 1,250. But the recovery took a couple years.
But don’t forget Commandments #1 and #2.
4. Thou shalt, at all times, beware of the mathematical realities of short selling.
When you buy a stock, hoping it will go up, the most you can lose is what you invested—while there’s no limit to what you can win. That’s a pretty good trade-off.
However, when you sell a stock short, the very best result—if the stock falls to zero—is that you double your money. But if the stock goes up instead, there’s no limit to the amount you can lose! That’s not a great trade-off.
5. Thou shalt not get greedy.
When you put it all together, it becomes clear that selling short is a high-risk proposition that can only work during certain periods, and even then, it’s unlikely to work for long. So when you find yourself with a profit from selling short, take some off the table. Let some ride, if you like, but remember that eventually, the market’s long-term upward trend will return, and it will be hard to swim against that tide.