Learning about short selling has to be more than just learning what the definition is. You have to be able to learn a practical, hands-on way, to find good stocks to short. That's exactly what this lesson is about.
What is Short Selling in Finance
Short selling in finance is when you sell a stock that you don't currently own (so you have to borrow from your broker on margin), thus you are paid now, with the agreement that you have to buy the stock back at a future time. The idea is to buy the stock back to cover the short when the stock is a lot cheaper. That way you pocket the difference between the original short sale, and what you have to buy the stock back at to cover the short.
What is Buying on Margin
Buying on margin means that you are borrowing money from your broker to trade. Your broker charges you interest on the loan. When you short a stock, you must have a margin account because you are borrowing money when you execute the short sale (you are paid immediately). The money is not outright yours until you cover the short (buy the stock back) and your broker stops charging you interest on the short position.
Stock Market Short
Before you start searching for good stocks to short sell you need to make sure you are trading with the broader market and not against it. Go to Finviz and chart SPY. Note: Depending on when you read this lesson, SPY will look different from when I created this lesson on 11/10/2013. That's ok. Just apply the same concepts to your chart of SPY (S&P 500).
Here is the chart of SPY (click on image below to enlarge):
This a good setup for stock market short selling. SPY is at the upper trend channel wall and it is very close to being overbought on the RSI. Before we proceed to finding a good stock to short sell, it is important that you understand the relationship between SPY and individual stocks.
Think of SPY (S&P 500) as the oceanic-tide. Think of individual stocks as boats in the ocean near land. When the tide comes in, all boats have a tendency to rise. When the tide wanes, all boats have a tendency to lower.
With SPY near overbought, let's count the total number of stocks that have overbought chart patterns.
Go to the Finviz home page, click on “Screener”, then in the Signal box select “Overbought”:
If you scroll down you will see on the far right side of the page a total count (just above all the charts). My total count reads “Total: 56”:
Now click on the Signal box and select “Oversold”:
My total count now reads “Total: 24”.
Shorting Stocks Rules
The most important point of all shorting stocks rules is to short with the market and not against it.
There are more than double the number of overbought stocks than there are oversold stocks. This makes sense because the market (SPY) is very near overbought itself as it tests the top of the trend channel wall resistance. This means that the broader market may be on your side with a short trade and so you have a green light to look for the best stocks to short today. Had the opposite been true, that is SPY was oversold and at major support so that most stocks were oversold instead of being overbought, you would be shorting against the larger market which means your probability of having a winning short trade drops dramatically.
Best Stocks To Short Sell
The best stocks to short sell are going to be stocks that are near overbought and that have a negative catalyst for pushing the stock lower. To get good at picking negative catalysts, go to the Finviz home page then click on the stocks that are the day's “Top Losers” and go through the news releases:
For example, let's take the first stock Tremor Video (TRMR).
TRMR reported disappointing third-quarter results. They also lowered their forecast for the 4th quarter. As a result of the poor earnings and lowered 4th quarter guidance, three downgrades hit the stock from Jefferies, Oppenheimer, and Canaccord Genuity. Bad earnings and lowered guidance with downgrades is an explosive downward catalyst.
Let's look another stock on the “Top Losers” list: SMF Energy (FUEL).
FUEL had its IPO at the end of September. The stock ran up to $65 a share shortly after the IPO which put a market cap on the stock of $2.1 billion. FUEL doesn't make money so they have no P/E ratio. They have revenue of about $30 million a quarter or $120 million in revenue per year. There's no way that a company that does $120 million in revenue per year should be valued at $2.1 billion. A company can have all the revenue in the world but if it doesn't make it to the bottom line, it doesn't mean much. They lost $1.8 million dollars last quarter which was a bigger loss than many had hoped. Because FUEL was an IPO, it had a 30 day limit restriction for the underwriters on short selling. As the 30 day limit expired on short selling at the end of October, the short sellers began moving in. A bigger loss than forecast and the 30 day moratorium on short selling an IPO can be big downward catalysts.
To find good short sell stocks you need to get good at picking the “story” or the downward catalyst that can drive a stock lower. To get good at figuring out downward catalysts, go through the “Top Losers” list on Finviz and read the news releases to see if you can determine the catalyst.
Frequently Asked Questions about What Is Short Selling: Good Stocks To Short
What's shorting a stock?
Shorting a stock is a type of trade where a trader makes money if the stock goes down in price.
Short selling is the selling of a stock that you do not own thus you need to have a margin account with your broker.
When you short a stock, your broker will lend the stock to you. The shares are sold and the proceeds are credited to your account. At some point, you must “close” the short by buying back the same number of shares (called covering) and returning them to your broker.
Wall Street Survivor posted the excellent video below called Understanding Short Selling.
What stocks short gold?
The best way to short gold is through a short gold exchange traded fund (ETF).
The largest short gold ETF is the ProShares Ultra Short Gold (GLL). The ETF is designed to deliver twice the daily inverse return of gold bullion prices.
If you do not want twice the inverse, you can go with the PowerShares DB Gold Short ETN (DGZ).
Gold miners have falling profit margins when the price of gold goes down. You can short gold mining stocks with the Direxion Daily Gold Miners Bear 3X Shares (DUST).
MorpheusTrading posted the video below on December 15, 2011 called Selling short gold ETF (buying the inversely correlated GLL). While the video is several years old, it does show you how MorpheusTrading does technical analysis on GLL.
What does overbought stock mean?
An overbought stock means that demand for a stock has push the oscillator (RSI, stochastic, etc) indicator to its upper boundary. Traders interpret the oscillator at its upper boundary to mean that a stock is overbought and may now experience a pullback thus it's a good stock to short.
Traders use overbought stocks to find stocks to short. In the chart above you can see how the oscillators, after signaling the stock ARCW was overbought, the price of ARCW fell some 50% from its high.
The RSI overbought level is 70. The stochastic overbought level is 80. The William %R overbought level is -20. The Ultimate Oscillator overbought level is 70.
As you can see in the chart above, oscillators mostly show the same thing and so you should have no more than one oscillator that you use.
TheTradersHaven posted the excellent video below called Overbought and Oversold Levels. The video is for the FOREX market but the same logic holds true for equities.
Manny Backus posted the great video below called Ultimate Oscillator: A Tool for Determining Overbought and Oversold Conditions.
PerfectStockAlert.com posted the awesome video below called Trading with the Ultimate Oscillator.
PennyStockAnalysis posted an excellent video below where he combines the RSI with the ROC in order to play overbought and oversold stocks.
DayTraderRockStar posted the awesome video below called The Ultimate Indicator: The Stochastic Divergence. He shows you how, once a stock is overbought or oversold, you can use a stochastic divergence to time the next sell off or rally.
Remember that to short stocks, you must set up a margin account with your broker. You can't short individual stocks with a cash account. Simply contact your broker and ask to fill out the required paperwork for a margin account.