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Buying Long, Selling Short
Day traders buy stocks in the hope that their price will go higher. This is called
buying long
, or
simply
long
. When you hear me or a fellow trader saying, “I am long 100 shares AAPL,” it
means that we have bought 100 shares of Apple Inc. and would like to sell them higher for a
profit. Going long is good when the market is going higher.
But what if prices are dropping? In that case, you can sell short and still make a profit. Day
traders can borrow shares from their broker and sell them, hoping that the price will go lower
and that they can then buy those shares back at a lower price and make a profit. This is called
short selling
, or simply
short
. When people say, “I am short Apple,” it means they have sold
short stocks of Apple and they hope that prices will drop. When the price is going lower, you
owe 100 shares to your broker (it probably shows as -100 shares in your account), which means
you must return 100 shares of Apple to your broker. Your broker doesn’t want your money; they
want their shares back. So, if the price has gone lower, you can buy them cheaper than you
bought them earlier and make a profit. Imagine that you borrow 100 shares of Apple from your
broker and sell them at $100 per share. Apple’s price then drops to $90, so you buy back those
100 shares at $90 and return them to your broker. You have made $10/share or $1,000. What if
the price of Apple goes up to $110? In that case, you still have to buy 100 shares to return to
your broker because you owe them shares and not money. Therefore, you have to buy 100
shares at $110 in order to return 100 shares to your broker. In that case, you will have lost
$1,000.
Short sellers profit when the price of the stock they borrowed and sold drops. Short selling is
important because stock prices usually drop much more quickly than they go up.
Fear is a more
powerful feeling than greed
. Therefore, short sellers, if they trade right, can make astonishing
profits while other traders panic and start to sell off.
However, like anything in the market that has great potential, short selling has its risks too.
When buying stocks of a company for $5, the worst case scenario is that the company goes
bankrupt and you lose your $5. There is a limit to your loss. But if you short sell that company
at $5 and then the price, instead of going down, starts going higher and higher, then there won’t
be any limit to your loss. The price may go to $10, $20, or $100, and still there will be no limit
to your loss. Your broker wants those shares back. Not only can you lose all of the money in
your account, but your broker can also sue you for more money if you do not have sufficient
funds to cover your shorts.
Short selling is a legal activity for several good reasons. First, it provides the markets with more
information. Short sellers often complete extensive and legitimate due diligence to discover
facts and flaws that support their suspicion that the target company is overvalued. If there were
no short sellers, the price of stocks could unreasonably increase higher and higher. Short sellers
are balancing the market and adjusting prices to their reasonable value. Their actions are
conducive to the health of the market.
If the price is going to go lower, you may correctly ask, why does your broker allow you to
short sell instead of selling stock themselves before the price drops? The answer is that the
broker would like to hold their position for the long term. Short selling provides investors who
own the stock (with long positions) with the ability to generate extra income by lending their
shares to the shorts. Long term investors who make their shares available for short selling are
not afraid of short term ups and downs. They have invested in the company for a good reason
and they have no interest in selling their shares in a short period of time. They therefore prefer
to lend their shares to traders who wish to make a profit from short term fluctuations of the
market. In exchange for lending their shares, they will charge interest. Therefore, by short
selling, you will need to pay some interest to your broker as the cost of borrowing those shares.
If you short sell only during the same day, you usually will not need to pay any interest. Swing
traders who sell short, usually have to pay daily interest on their short stocks.
Short selling is generally a dangerous practice in day trading. Some traders are long-biased.
They only buy stocks in the hope of selling them higher. I don’t have any bias. I will short sell
when I think the setup is ready, and I will buy whenever it fits my strategy. Having said that, I
am more careful when I short stocks. Some strategies that I explain in Chapter 7 work only for
long positions (Bull Flag and Bottom Reversal). Some strategies work only for short selling
(Top Reversal) and others will work in both long and short positions depending on the setup. I
explain these positions in detail in Chapter 7.
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