If you ever watched or read The Big Short, you might have found the story interesting and wondered how those traders got short. You might have even thought about shorting some stocks yourself, but did know what to look for.
There are some things you’ll need to be mindful of when you’re shorting stocks, such as margin, short interest, floating shares and days to cover.
First things first, if you’re looking to short stocks, you should have an adequate amount of capital lying around, and you should understand that you could lose more than you intended to. Now, when you short stocks, you’re going to need a margin account, as this is the only type of account that could be used to short sell stocks due to regulations.
Now, under Regulation T, short sellers must place at least 150% of the value of the short position when the short is held in a margin account. Don’t worry, the 150% consists of the full value of the short position, or 100%, but you’ll need to put up an additional 50%. A margin account is required since you would be selling something you do not currently own by borrowing shares from someone else.
Trader Jason Bond noted, “When you’re looking to short sell stocks, you should keep in mind that you could lose a lot more than you invested. If you’re short a stock that is in a short squeeze, and you do not fulfill the minimum margin requirement, your broker will most likely close out your short at an unfavorable price.”
The next thing you’ll want to know about short selling is that the lower the number of floating shares, the more volatile the stock could be. Additionally, if there is a low number of floating shares, coupled with a high number of shares short, that stock could be in for a short squeeze. A short squeeze simply occurs when there is a sharp move to the upside, and short sellers close out their positions and add to the buying pressure, and in turn, the stock continues to run higher. Floating shares is the number of shares available to trade. The lower the number of shares available to trade, the more the stock fluctuates due to supply and demand aspects.
Now, short interest is one key metric you would need to take into account when shorting. If there is a high short interest and the stock has been beaten down, you might not want to initiate a short position. Short interest is the ratio of the number of shares short to the number of floating shares. When there is a high short interest and a positive catalyst, traders may know the stock could undergo a short squeeze and could rise significantly.
Days to Cover.
Days to cover is a ratio that could give you an idea of when the buying pressure may be in the cards. Days to cover is the number of shares short divided by the average daily share volume. Therefore, if the days to cover ratio is high, it could be an indication that traders may start to close their short positions, thus increasing buying pressure.
The Bottom Line.
These are only a few metrics that you would need to take into account when short selling. There’s a lot more that goes into finding short plays, but looking at these metrics will give you a jump start. Keep in mind, you shouldn’t trade solely off of these metrics, rather you should use them as learning tools before you develop a strategy to short stocks.