A Short Lesson on Shorting Stocks

Hey, mooers!

Definition 📚

Sarge said short selling is essentially borrowing shares of a stock you don't own, selling them at the current market price, and hoping to buy them back later at a lower price. It's a tactic that can potentially be lucrative but also comes with significant risks. For example, you borrow shares of a stock trading at $100 each and sell them, and if the stock later falls to $90, you can buy it back at a lower price, return the shares, and keep the difference minus any fees and commissions. However, if the stock rises to $120, you'll incur a loss when you buy it back at a higher price.

Sarge explained that short selling can indeed be used as a hedging strategy, which is where the term "hedge fund" originated. For example, if you like two similar stocks but think one is better, you might go long on the one you prefer and short on the one you believe is overvalued. While it decreases your chances for overall gain, it also generally reduces the risk of significant loss, which should help provide some protection with the potential for a moderate profit.

Sarge pointed out you generally have a long period to cover your short position, but it is not unlimited. The key is to avoid a margin call and retain the short position hoping to exit the trade with a profit. Some traders, like those who shorted Tesla for years, faced significant losses when the stock price rose drastically. Sarge discusses having target prices for your shorts and being ready to cover them more quickly than your long positions. Despite his extensive experience, Sarge emphasized that he has far less confidence in short positions compared to long positions, and he personally does not like being short for a long time.

Fees Associated with Shorting ✒️

Sarge mentioned shorting stocks incurs borrowing fees, which are essentially interest charges. The longer you hold a short position, the more interest you will be charged. Most retail brokers do not charge commissions on equity trades but do charge interest on borrowed shares. If you use short positions as a hedge against a long position in a similar stock, you might end up holding the short position longer, and the fees can add up over time. Sarge highlighted that if your short positions are a trade, you probably won't be hurt too bad by your interest fees because you likely won't hold the position for that long. However, when used as a hedge, the duration may extend, increasing the overall costs.

Restrictions on Shorting 🧮

Sarge clarified that not every stock can always be shorted; you need to borrow shares from someone willing to lend them. This is usually not an issue for most stocks, but in times of extreme liquidity variations, you might receive a message from your broker indicating that there are no shares available for you to borrow, hence preventing you from shorting the stock.

To identify a possible short candidate, Sarge looks for 'overvalued' stocks relative to their peers and historical valuations. He suggests examining various valuation metrics like P/E ratios, price-to-book, and price-to-sales ratios. He combines technical analysis with fundamental analysis to evaluate whether his short idea is sound. Additionally, Sarge avoids shorting stocks trading under $5, as they may have limited downside but significant upside risk. He prefers shorting higher-priced stocks where the potential reward is more substantial.

Sarge outlined that short interest alone may not indicate if a stock is overbought, as seen during the meme stock craze when high short interest led to short squeezes despite low prices. Sarge talks about using the relative strength index (RSI, a momentum oscillator that measures the speed and change of price movements) and daily MACD (Moving Average Convergence Divergence, a trend-following momentum indicator) on technical charts to assess if a stock is overbought. When researching a stock for a long trade, Sarge considers high short interest as an incentive to buy, suggesting bullish potential since many bears have already shorted the stock.

Sarge explained that a short squeeze occurs when a heavily shorted stock starts to rise, forcing short sellers to buy back shares at higher prices to cover their positions, which in turn drives the price even higher. He avoids stocks where more than 8-10% of the float is already held short. This indicates a crowded trade and usually increases the risk of a short squeeze. Sarge also mentioned that his warning signal goes off if he sees that everybody else has already thought of this name as a short. Therefore, it's a crowded trade, and he is not early to the trade.

Sarge remarked that shorting stock involves an equity position, while trading options can create a synthetic short with less capital risk. A synthetic short can be constructed by buying puts or creating a bear put spread, which limits potential losses compared to outright shorting. For instance, buying puts may be a safer way to achieve a bearish position with less capital at risk.

Another method is selling calls, where you gain the premium if the stock goes down, but face potentially unlimited losses if the stock rises. Overall, Sarge suggests considering synthetic shorts like buying puts or bear put spreads to help better manage risk than outright shorting the underlying stock.

Hedge by Call 🖋️

Sarge said apart from using stop orders, you can buy calls to try to hedge against significant losses if the stock moves against you. Sarge has a rule of not being willing to lose more than 8% in any equity position. He also practices dollar-cost averaging but limits it to two times before deciding to exit the position.

Sarge advised that selling puts without having the cash to secure them is a risky strategy and incurs interest. If the stock goes against you, you will have to buy the shares at the strike price, making it one of the riskiest trades you can do. Sarge advises against this approach, calling it dangerous.

Shorting Stocks in a Down Market 📅

Shorting during Earnings Season 📊

🌟 Mission accomplished, mooers! Remember, the market battlefield is unpredictable; Even the most seasoned traders can't win them all. But with Sarge's strategies in your arsenal, you might earn your stripes needed to keep up.

Remember to tune in next week for another live session with Sarge. Until then, keep your portfolios polished and your ratios razor-sharp! 💼✨