Short Sale - How to Profit in a Bear Market

What is a Short Sale?

A short sale is when a trader borrows a stock on margin and sells it on the open market.  These borrowed shares will come from the inventory of the trader's broker.  Traders profit on short selling by first selling the security, then buying it back at a lower price.   However, if the security rises, the trader will incur a loss.  

What Accounts are Approved for Short Selling

A trader must have a margin account in order to short sell.  Each brokerage firm has different margin requirements that must be upheld to keep the account active.  Most brokerage firms require the trader maintain a minimum balance of $2,500 cash to open an account and then there are specific margin requirements for each security.

Fees Associated with Short Selling

When a trader shorts a stock he or she will incur interest for the margin used to borrow the stock.  Margin interest rates range from 4% - 8%.  The simple interest is calculated on a daily basis and is debited from your account at the end of the month.  If you only carry a security for two days, then the trader will only have to pay interest for that holding period.   

Risk of Selling Shares Short

Short selling is viewed as one of the riskiest forms of trading.  Unlike buying a security, where your losses are limited to what you put up, the risks with short selling is unlimited.  For example, if you short sale a stock at $12.50 and it gaps up overnight on a buy out announcement to $35, you have just loss 280% of your capital.  So, if the trader shorted $5000 worth of stock, he or she has loss the initial $5,000 and now owe the brokerage firm $9,000.

Short Selling Trading Strategies

There are a number of strategies that can be used to profit on the falling value of a security.  Traders can increase their odds of success by first determining if the overall market is in a downtrend.  The next step is to identify the weakest sectors within the market.  This top down approach will ensure the trader locates the weakest stocks which have the greatest of odds of continuing lower in the near future.  Traders should stay away from penny stocks, as short squeezes in these securities can be as high as 50%-75% in a matter of days.  Traders should focus on securities priced over $20 dollars that have a high float.  This will also ensure the broker does not have strict margin requirements for the security.  At times, if a stock is too volatile a brokerage firm will require the trader have 200% of the value of the position in cash, and some brokerage firms will remove the stock from its easy to borrow list altogether if it appears to be too volatile.  We have all seen this during the '08 credit crisis, as the SEC removed over 800 stocks from the allowable short list.
Tim Ord
Ord Oracle

Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...
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