Investment Tips 13-04-2023 20:18 111 Views

Best Trading Strategy for Shorting Stocks in 2022

Short selling stocks… I know this was probably a very taboo topic in 2020-2021, but hey guess what, if you don’t use this kind of trading strategy to your advantage in 2022, you are missing out on some massive profits.

How do you make money when the market is going down? People are traditionally trained to buy low and sell high in order to make money. But what do you do when that doesn't work anymore? 

Background

Let’s imagine for a second that you jumped into the stock market way back in 2020 or 2021 when the stock market was extremely hot and everything was flying to the moon.

We had electric vehicle stocks going from single digits to double, SPAC stocks quadrupling every other day, and Meme stocks were just ripping the sky. No matter where you put your money, it made you even more money.

But now in 2022… the market is much different. There's the

  1. Threat of global nuclear war

  2. Rising interest rates

  3. The stock market is selling off for months now

  4. And Comedians can’t even tell jokes at the Oscars anymore without getting b**** slapped… 

I guess I better watch my bad jokes now…

So all of this begs the question, how do you make money when the market is going down? People are traditionally trained to buy low and sell high in order to make money, but what do you do when that doesn't work anymore?

Well, the answer is you flip and do the opposite… you sell high then buy low. That's what we call, short selling.

Bubble Tea Example

Alright let's first discuss… Why short selling? Let's say you went to a bubble tea store and you were really impressed with their drinks. The pearls are fresh and chewy. They bounce right off your teeth, the menu selections are creative, the milk tea smells great, and customers who drink the bubble are all extremely satisfied and share photos on Instagram.

So you say to yourself, this bubble tea shop is the company of the future and they are going somewhere. I definitely should buy shares of the bubble team shop.

When you buy or go long on shares of a stock (BBT), you are betting that the stock is going higher. Essentially, your thesis is that the bubble tea company is going to get even better over time.

What if you went to that bubble tea shop again a few years later and had a much different experience? The milk tastes powdery, the pearls are soggy and the customer service just stinks like smelly tofu. The experience now will make my ancestors cry.

So you say to yourself, this company is garbage. They are definitely going out of business soon. Now, instead of wanting to buy shares of the company, you want to bet against it. You can do so with short selling.

Short Selling Explained

Short selling is essentially betting against a company, or index, etc. You are making a thesis that instead of going up, the stock is going to go down. If you were like me, when I was brand new to day trading years ago… I thought to myself… man whatever I bought, tanks immediately after, and I sold at lows for a huge loss.

That's when I realized I should just do the opposite and short sell instead!

How to Short a Stock

Now we understand the fundamentals of short selling. Let's talk about exactly how to short a stock. Let's say you’ve identified this stock you want to short. Okay let's not use BBT because that's a real company. Let's use… MRNA. 🤬🤬🤬

Most broker platforms do not have a “short sell” button, so if you want to short MRNA stock, you have to press the “sell” button first, in order to execute the short sell and open a short position.

Then, when you want to close this short selling trade, you would need to click the “buy” button to buy them back. At this point, you must be wondering, “Alright Shay, let me get this straight. If I want to short sell, I start by selling something I don’t have, and I buy back something I don’t have to get rid of it?

Yes, but don’t worry. It’s actually more complicated than that, but don't worry. I got you.

In short, pun intended, all you really have to know is sell high, buy low. The exact opposite when you buy a stock.  Yes, when you are shorting a stock, you are essentially selling shares to someone else first... Selling something you don’t have?

Short Selling Brokers

To do so, you would have to borrow those shares first from your brokers. Some common brokers where you can borrow shares to short from are:

  • TradeZero, if you have a small account

  • Interactive brokers, if you’re just shorting large caps and not small caps 

  • Cobra Trading or Centerpointe if you have a bigger account

  • Robinhood, okay maybe not RH, especially if they’re gonna suspend the “buy button”

The brokers I just mentioned are the brokers I personally use to borrow stocks to short. These brokers let you borrow them out of the kindness of their hearts, right?

No.. In fact, they charge you a fee to do it, because they are effectively loaning you shares. The price you pay for short-selling their stocks is the fee. Think of it like a credit card, except this one could actually make you money.

Among these brokers, there are some that are great for easy to borrow stocks and some that are best for hard to borrow stocks. 

After you paid the fee to borrow 100 shares to short MRNA and you clicked the sell button to short sell, then it's time to hold on to your dear life and pray that the stock plummets… like MRNA.

Every single penny that it goes down is money in your pocket, and when you've had enough fun watching this shit stock drop to rock bottom, then it's time to close your short position and collect those profits.

Closing the Short

To close that short position, you need to click the buy button to buy to cover your short. If you were short 100 shares, then you need to buy back 100 shares. Remember, the reason you have to buy back those shares is because you sold shares that did not belong to you.

Since we borrowed those shares to sell in the first place, we now have to buy those shares back from someone else to close this trade. Except, this time around, you are buying shares of MRNA stock at a much cheaper price than when you originally sold them… hopefully.

Profits

Now, let's talk about profits. Let’s say MRNA was $178 at the open when the stock opened red below prior days close, and the stock plummeted to $177. If you were to close that short position here, you’d profit $1 a share, which would be $100, or around 14 bubble teas.

However, if you believe gravity will take this stock back to where it came from and you wait to buy those shares back until it hits $168, then we’d make $10 points a share, which would be a $1000 profit, or 143 bubble teas.

I think it's clear at this point that we should make bubble teas the world reserve currency.

Okay, I know at this point we are both happy about shorting Moderna stock to buy food, especially in 2022 as stocks keep on selling off. This sounds like a great trading strategy that will never fail… right?

Unlimited Losses

Well, not quite. The biggest risk of Short Selling is the potential for unlimited losses

What does that mean exactly? When you buy or go long 1 share of MRNA for let’s say $100, that means the most you could lose is $100, and 3 days sick in bed. This is because the lowest price the stock could fall is to $0, so you have defined risk.

However, when you sell short 1 share of MRNA for $100, you are betting that the price is going down under $100. What if the stock ended up flying a lot higher than you had expected?

What if at the next earnings report, MRNA announced that they found the cure for cancer? What if the business is getting into NFTSs? How high would the stock price go?  $200? 400? All-time highs of $500 or even higher to $1000?

The point is we do not know; there is no limit to how high the stock price could go. Therefore, it is an undefined risk. If a stock you are shorting keeps on going higher, you could potentially get a margin call.

Margin Calls

A margin call happens when your ex-husband, Bagholder Mike, is no longer able to carry those heavy bags for you. Just kidding, am I gonna get slapped for all the bad jokes in this article?

A margin call is where the broker tells you that you need to put in more money to maintain your losing position. If you can’t, the broker will close out your trade and realize your losses for you.

Some brokers won’t even notify you ahead of time, because they have an algorithm in place that automatically closes out your trade when your unrealized loss is at a certain threshold, because the brokerage does NOT want to take on that risk.

Margin call is important when it comes to short selling, especially if you are a new trader. Failure to follow your risk and you could risk blowing up your trading account. If you want to learn more about trade planning and risk management, feel free to check out the Humbled Trader Community.

Hopefully this article makes the mechanics of short-selling a little bit easier to understand.


Don’t feel like reading? Watch the video.

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