7 Things You Should Know Before You Short a Stock

“As a very successful investor once said: “The bearish argument always sounds more intelligent.”
-Peter Lynch, One up on Wall Street

The stock market is the greatest wealth creation machine ever created.

But every so often, you're going to be tempted to bet against the market, or a particular stock or ETF.

Maybe you see a technical pattern you don't like.

Maybe you see an economic downturn coming.

Or maybe you think you've spotted an outright scam.

But shorting is not as simple as you think.

Shorting requires an intimate understanding of market mechanics, and the harsh reality that stocks sometimes go up for no good reason.

So let's go through 7 things you absolutely need to know before shorting a stock or ETF.

1) Understand What Shorting Really Is

Shorting stock isn't quite as simple as buying it.

Shorting requires borrowing shares from another investor. Your brokerage firm facilitates this process for you.

Then, you sell those shares in the hope that they'll fall in price.

If it drops, you'll buy the shares back (which is called ‘covering' a short), capturing a profit.

For example, if you sell Amazon.com (AMZN) at $1000 and buy it back at $950, you've earned a profit of $50 per share.

2) You Can't Short Everything You Want

Not every stock is available to be shorted because it can't be borrowed.

Typically, when a stock is widely disliked or is facing a scandal, it will be so heavily shorted that your broker simply won't be able to locate shares for you to short.

Every brokerage platform has some mechanism for indicating that a stock is hard to borrow, or not available to borrow at all.

For examples, as of June 12, 2017, shares of the troubled radio company Cumulus Media (CMLS) can't be borrowed.

With the company rumored to be on the brink of collapse, it's already attracted plenty of shorts.

So there are no shares left for new potential shorts to borrow.

3) Know Your Expenses and Margin Requirements

If you want to short stocks, you are required to have a margin account.

And you must have enough capital in your account to back up your short positions.

For example, if you want to short $10,000 worth of stock, you may be required to have $5,000 of cash in your account.

Plus, shorting isn't free.

To short a stock, you have to pay your broker a “stock loan fee.”

And the more volatile a stock is, and the more difficult the shares are to borrow, the higher that fee is.

Check with your broker for exact terms.

4) Realize That the Interesting Bear Argument Always Sounds Better

Most investors want the stock market to go up.

But many traders are attracted to contrarianism, and the often-sexy arguments of bears.

For example, for years many bears have used obscure financial metrics like the Schiller PE (CAPE) Ratio, market cap to GDP ratio, and NYSE Short Interest to imply that the SPX is overvalued.

These arguments always sound a lot more clever than the typical bull rationale, which revolves around plain old earnings and economic growth.

And yet, the market's done nothing but gone up:

So think twice before buying into doomsday scenarios, no matter how attractive they sound.

5) Don't Short Momentum Stocks on Valuation

Never short a stock simply because it's trading at 50 times earnings.

You know why?

Because it might be worth 60 or 70 times earnings a week from now.

Momentum stocks have a tendency to go way farther than may seem reasonable, especially if they are reporting strong earnings.

We suggest watching Scott Redler's recent video lesson Facebook (FB) so you can see how a stock with consistently strong earnings can destroy the bears:

And look at momenutm favortie Salesforce.com (CRM).

It's regularly been called overvalued throughout this bull market:

Now look at this chart:

The bears — as smart as they may be — have been wrong.

Why?

Because traders love to buy momentum stocks with strong earnings.

6) Your Timing Must Be Impeccable

If you want to short a hot stock or the market as a whole, you need great timing.

Being right doesn't matter if you're not right at the wrong time.

For example, many experts correctly called the housing bubble and subsequent collapse of the financial system very early. We're talking 2004 or 2005.

But bank stocks didn't peak until December 2006.

And in the last 5 years, how many times have you heard that there's a bond bubble?:

The bond bubble people may be right… but the TLT chart hasn't really broken yet, has it?:

7) You Are Betting Against Gravity

The S&P 500 has returned an average of 11.4% since 1928, according to NYU Professor Aswath Damodaran.

And when it's rising, even the worst stocks can go up.

So you are betting against the market's reverse gravitational pull towards the sky.

We're not saying you can't make money shorting.

Just be careful!