Special Report: Short Selling 101

Picture this: It’s November 2020. 

GameStop share prices are roughly $12 a share and you think there may be a pop in its stock at the end of the month when the PS5 and Xbox Series X come out. 

Nothing much pops, but you don’t sell your shares. 

You wait a few months, scroll through your apps, and see this:

robinhood, gamestop

Source: Robinhood 

You’re probably wondering what even happened to cause GameStop (NYSE: GME) to go up so high. 

It all started with hedge fund Melvin Capital deeming GME a smart investment if you short sold it, meaning to bet on a drop of company shares.

It was betting on GME dropping in price. 

Think of what happened next as pulling a “reverse" card in Uno

Masses of people bought then-cheap shares of GME, which resulted in the stock price rising. To prove a point, they aimed to get GME in the $20-a-share range.

It peaked at $483. 

The frenzy that ensued demonstrated the power of the internet for sure. 

Melvin Capital lost so much covering the shares bought that another hedge fund had to dig it out with a $2 billion bailout. 

This is a perfect example of a “short squeeze.”

People saw that a stock was going to be shorted, so they countered by buying up the stock, causing the price to go up. 

The people who managed to do this weren’t experts — just people with basic knowledge of the stock market and an internet connection. 

Which is probably why you’re reading this rather than watching The Big Short to get a better idea of what shorting stocks is. 

Hypothetically, let’s say “Company X” is overvalued, but a new round of competitor products are about to be released, which could possibly cause a dip in Company X.

You’re also aware that in a couple months a product from Company X is going to be released, which will potentially cause it to climb back up from the dip it's in. 

If you’re quick on your feet, you go to Robinhood or E-Trade and you’re “lent” some shares of Company X where they’re sold at the current market price.

You can borrow shares of stocks through online brokers like TD Ameritrade — most don’t have an account minimum. You can’t use your standard app for borrowing shares. 

You wait for Company X to dip, you buy the shares back, and boom.

You turn a profit from the difference of the price at which you bought the share and where you sold it. 

Again, we’re here because of GameStop, possibly the most historic short squeeze. 

It’s pretty cool that it’s also one of the only ways to profit off a bearish company or market.

Like any market trend, there are some risks. 

Perhaps you miscalculated and Company X's price triples. Then you end up owing money. 

The bigger concern is if the risks are worth it.

A few tips here could definitely help you weigh out the risks. 

Think of the tips below as your study guide for shorting stocks. Don’t worry, there won’t be a pop quiz after. 

Timing Strategies

The cheaper the stock, the more shares you can buy. This is pretty obvious.

The reason why you saw multiple memes on “holding the stock” and “not selling” GME is because the people who bought the stock were waiting for the highest price point to sell back their shares and collect the difference.

But we all know now how quickly that lasted. GME's share price dropped to one-fifth of its peak price in five days. 

Say you’re looking at certain markets and a company piques your interest — maybe you’re familiar with the founder or you like what the company does. 

But you look into the company’s stock and the progress of the stock price resembles a mountain, with one line going up and then going back down. 

downtrend

So what are the ways you could have profited off a 24-hour endeavor like the GME short? 

Day trading would have been a unique approach. 

Obviously, being “Holly Hindsight,” you should have taken up shares the day before the spike.

Day trading investors typically use timing the same way people gamble on roulette. 

Monitoring trading hours, a day trader focuses on only one or two stocks because of such a short-term hold on their shares. 

So if you were part of the Reddit storm on GME and knew what comes up must come down, you may have decided to sell your shares at the end of the day and most likely would have still pocketed a good amount of money.  

Honestly, with the GME craze, you could have also scalped shares, which is exactly what it sounds like.

With scalping, you’re basically doing the same thing as day trading but in a shorter time span. 

If you invest in shares and get your profit, you call it quits right there. 

Scalpers believe it’s better to cut their losses rather than waste time so they can move on to the next opportunity. 

Scalpers have the edge of high frequency — because of trades lasting mere minutes, a scalping investor can jump between multiple trades on a standard day. 

If done correctly, day trading and scalping could definitely benefit you, but if you make the wrong calculation, you could lose your entire investment. 

What Is Going on in the Market?

Assessing the market is something you can’t fly over. 

To see the value of a company, you compare its price with the price of its market.

This gives you a good idea if you should search more in your chosen market for a better company to invest in OR if you need to assess any competition that could possibly affect your chosen stock. 

With GME, the advice to short the stock was made on the basis that it was not significant to its market anymore and that betting on its decline was a sure thing.

Taking into account the environment around a company is crucial — you can’t be unaware. 

Let’s take Virgin Galactic (NYSE: SPCE) as another example.

Remember when Virgin Mobile was a thing? 

Same founder (Sir Richard Branson), different outcome. 

After just a tweet confirming two test flights, SPCE decided to pop. 

The pop was so high SPCE hit an all-time closing high at $53.79 a share. 

A 21.5% increase in share price is surely something to brag about. 

But what goes up must come down. 

The next day, share prices dropped almost 5%.

A stock-savvy investor would note that there are simply better companies in the space market. They would consider many different companies like ones that are contributing to NASA projects. 

The same investor would have heavily considered shorting SPCE because of their knowledge of better companies in the same market and that there was no chance Virgin Galactic would maintain a high. 

Put Contracts: Buying the Rights, Not the Stock Itself

As a stock price goes down, the price of what is called a "put contract" goes up.

A put contract is basically the right to sell a certain stock at a certain price within a certain amount of time. You purchase one when you're fully confident that a stock price will decline before a chosen date.  

Let’s say you believe a company's share price will fall in the coming days/months (or even years if you're that confident and patient) for whatever reason. 

This is what the hedge funds did with GME.

They saw a failing business, a brick-and-mortar video game store. The fundamentals were failing and it seemed as if this company were doomed. So these hedge funds took heavy short positions once they identified a business they felt was destined to fail. One way a normal institutional investor would do this is by buying put contracts. 

You can view a list of put contracts on your brokerage if you’re approved for margin trading, or simply view put contracts on Yahoo Finance like so…

yahoo finance, GME

But think of it this way — say GME is trading for $100 a share. 

You think that is way too high a price and believe it will fall to $90 (we call this the “strike price”) within the next few weeks. 

You would set a date that you believe gives the stock enough time to move in your desired direction and view the contracts available. 

You purchase the right to sell “x” amount of shares at a certain price.

If the share's market price falls, you still have a certain amount of security. 

Then you buy a put contract (one contract comes with 100 shares) of GME at the strike price of $90 for $5 per contract with your desired expiration date.

You wait as you approach the expiration date and hopefully the share price drops. Now you’re in a position to sell your shares above the market price and profit off the difference.

You can also use this method with entire markets. 

Let's say you believe the S&P 500 is overvalued and has to come down. 

The first thing you would do is check out available put contracts.

yahoo finance, GME

With put contracts like these, you may be limited by the date. For instance, Yahoo Finance only lets you view contracts for December 17, 2021.

But other than there being fewer available options, the strategy for buying put contracts for an entire market remains virtually the same as buying puts for individual companies. 

Some things to consider while purchasing a put contract are the “bid” and “ask” price as well as “implied volatility.” 

The bid and ask prices are simply what the contracts are being bought for. Think of it this way: The bid is the maximum price a buyer would pay, and the ask is the minimum amount the buyer would pay. 

Implied volatility is pretty much exactly what it sounds like. Generally, you want to look for implied volatility in the 30%–40% range because it means the stock has a lower chance of being volatile. The higher the percentage, the more volatile the stock and contracts will be. 

And lastly, how to read a contract name. 

The components of the put contract symbol are the root symbol (which is the ticker) + expiration year (yy) + expiration month (mm) + expiration day (dd) + call/put (C or P) + strike price.

Put options are a great way for investors to take advantage of falling stock or market prices, but be careful because if you make a bet that a market or stock will fail and it succeeds instead, the risk could be unlimited. 

Side note: If you have massive short positions on a company, do not let the trolls of r/WallStreetBets find out. 

Inverse ETF Investing

A simple purchase is all you need — but instead of a stock, your purchase is only a fund. What’s unique about inverse ETFs is that margin accounts are not required. 

You also have a “safety net” of sorts. The worst that could happen is reaching zero. I know that still doesn’t sound wonderful, but would you rather owe money on top of your losses?

ETFs are betting on a sector as a whole rather than as a single company. The ideal outcome is where outturn of an investment meets the opposite of an index (benchmark) that it's related to. 

Take a fund related to the S&P index, for example. The fund reacts to the S&P’s overall performance. If the S&P index drops, the fund rises. 

An ultrashort ETF can provide up to three times the tracked index. If an index drops one point, an ultrashort gains three. 

What can construct an ultrashort is the futures or options that bet against an index, basically roiding up the downside bets. 

A perfect example is ProShares UltraPro Short S&P500 ETF (NYSE: SPXU), offering a 3x daily short leverage to the S&P 500 index. Think of it as a juiced-up version of ProShares Short S&P500 ETF (NYSE: SH).

Your Eggs and Your Basket 

As cool as it looks, a short sell can be risky business. 

Even the most rookie short-term strategies have the potential to turn against your favor. 

There’s no limit on how high a stock can go. If you think a certain stock is going to decrease and the opposite happens, you could see yourself out of money or even owing money. 

That’s a market risk.

When corporations take action, that is also something you can take into account. 

Obviously, there’s also the risk of a squeeze. It’s cool when you’re part of it but not cool when you’re trying to profit from shorting a stock.

short squeeze

Source: Investor Place

Remember, you’re on borrowed money.

Then if a short squeeze occurs on a GME-size scale, you may find regulators banning short sales. 

If there’s one thing to take away from the GME squeeze, it's that you can take advantage of an unstable market.

Sell high and buy low. Just make sure you don’t put all those eggs in one basket. 

The best thing about this report is that you can play mix and match. 

If you check out our premium publication, Outsider Club, you get to see what stocks are the best to watch. 

Then you can apply the stocks that catch your eye to any short-selling technique you see fit. 

In due time after reading our latest updates and news on the stock market, you could be winning big.


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