5 Things to Consider Before Short Selling Stocks

Developing and executing a short selling strategy can supercharge the returns of an average investment portfolio.

It’s a long-held piece of conventional wisdom that investing in the stock market is one of the surest ways to build wealth. And yet, in the wake of the COVID-19 pandemic, just 16% of Americans say the stock market is their preferred long-term investment vehicle.

Some of that is due to a mistaken belief that it’s not worth investing unless you have a large sum to commit to a portfolio. And others avoid the stock market because they don’t understand it.

But those might not be the only factors driving the trend. Another could be that inexperienced investors see the stock market’s volatility as a threat to their savings.

If you think about it, that makes good sense. It’s because the average investor tends to build portfolios based on long positions. That means they have to sit idly by whenever the market enters a downturn.

And if they need to access their capital, they have to take a loss to do so.

But that wouldn’t be the case if they developed a short selling strategy. Then they would be able to capitalize on those downturns and take profits when they need them most.

But even though short selling might make stock market investing more attractive to the average American, it does involve some risk. To clarify, here are 5 things to consider before short selling stocks.

1. Choose the Right Broker

Before developing a short selling strategy, the first thing to consider is how well your current brokerage accommodates the practice. Most brokers will place limits on short sales, and that can affect the strategy you develop – or prevent you from developing a strategy at all.

At a minimum, most brokerages will provide their clients with a list of securities that they may short sell without being subject to extra requirements.

And, it’s also common for brokers to insist on minimum deposit requirements to qualify an account for margin trading. So if you want to have the greatest freedom to execute short sales, it’s important to pick the right short selling broker to handle your portfolio.

That way you’ll have the greatest flexibility with the lowest initial investment, leading to greater opportunities for profit.

2. Understand Broad Market Trends

If you’re planning to create a short selling strategy, you must first take some time to learn about how broad market trends might affect your trades.

For example, most experienced traders learn early on to never begin shorting stocks in the middle of a bull market. This is because even experienced traders will have a great deal of difficulty identifying a stock that’s certain to decline when the broader market is trending upward.

So, although it’s tempting to try and utilize short selling to augment your earnings even when your portfolio’s on the upswing, it’s rarely a good idea.

Instead, take the time to watch how the broader market cycles tend to create opportunities for short sales. After getting a feel for the ebb and flow of prices, you’ll be much better situated to make smarter decisions for your short selling strategy.

3. Dedicate the Time Necessary to Succeed

A typical stock portfolio consists of long positions and therefore doesn’t require much day-to-day attention. In fact, you could even argue that taking a hands-off approach to managing your portfolio is the simplest route to long-term gains.

But short selling is a very hands-on activity. This means it’s something you shouldn’t take on unless you know you’ll have the free time it takes to do it right.

For example, if you work at a job that requires you to be on the road for significant stretches, short selling probably isn’t a strategy for you.

But if you’re a remote worker that has the time to follow the markets closely and make adjustments when necessary, you’ll have a better chance to succeed with a short selling strategy.

4. Avoid Chasing Media-Driven Downturns and Meme Stocks

Even though it’s possible to execute short sales that capitalize on media-driven events, it’s never a good idea to do so. The reason is simple.

The more that the downward price movement of a stock is publicized, the more short-sellers will try to take advantage of the situation. And crowded short sales create adverse conditions that can lead to major losses.

This is especially true when you’re dealing with share prices that are moving due to external factors. A perfect example is the recent price fluctuations associated with so-called meme stocks.

In their case, internet users were artificially inflating the prices of stocks like AMC and GameStop. And their purpose, more or less, was to punish large hedge funds that were betting against those companies through large numbers of short sales.

In essence, a crowded short sale market drew the attention of people that acted in concert to squeeze it. And it’s not just random groups of internet users that can make it happen.

Sometimes they’re the result of natural market forces, too. But more often than not, it happens when you’re trying to short a stock that’s getting an unusual amount of public attention. So it’s best to focus your strategy on shares that aren’t in the public eye.

5. Learn and Practice Adequate Risk Management

The most important thing to consider before you begin short selling stocks is that it involves risk. This is because the process of short selling relies on margin trading – meaning you’re working with borrowed capital.

This gives you the leverage to earn many times more than you’re actually investing. But it also means your losses can be much greater than you can absorb.

This is why it’s critical to include a risk management plan into your short selling strategy to make sure you don’t get in over your head. The key to this is adding some precautions to your trades, such as reducing your short positions as soon as they become profitable.

This reduces your potential gains, but it also reduces your potential losses if the shares move against you. It’s the most important thing you’ll need to understand and master before beginning to execute a short selling strategy. Otherwise, you’re asking for trouble.

The Bottom Line

At the end of the day, developing and executing a short selling strategy can supercharge the returns of an average investment portfolio. But it isn’t for everyone.

You have to prepare your plan in the right way, understand the risks, and be careful not to overextend yourself too far. Getting it right could unlock the doors to the kind of wealth-building that’s not possible through any other means.

And it could be just the thing that convinces would-be investors to come off the sidelines, comfortable in the knowledge that they don’t need to fear stock market volatility – but can instead turn it into an opportunity to accelerate their earnings.

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