Shorting Stock – Explanation

Shorting Stock is possible because assets can become overvalued, but is not for amateurs.

3 min read

Shorting Stock - Explanation 1

Shorting stock is when an investor borrows shares and immediately sells them, hoping he or she can scoop them up later at a lower price, return them to the lender and pocket the difference. But shorting is much riskier than buying stocks, or what’s known as taking a long position.

When some investor engages in an operation known as short selling, such investor borrows shares of a company from an existing owner through the brokerage, sells those borrowed shares at the current market price, and takes the cash.

Ordinarily, when you invest in stocks online, you hope to profit from a company’s good times and rising profits.

But there’s a whole other class of investors, called shorts, who do just the opposite. They search the Internet for news stories about diners getting food poisoning at a restaurant, for instance, and look for ways to cash in on the stock falling.

It’s possible to make money when prices are going down. Of course, if you are willing to accept the risks.

One strategy to capitalize on a downward-trending stock is selling short. Short selling is the process of selling “borrowed” stock at the current price, then closing the deal by purchasing the stock at a future time.

What does this essentially mean?

You turn a profit if the price drops between the time you enter the agreement and when you deliver the stock. But if it increases, you take a loss. You have to know that it is possible to short stocks, ETFs and REITs, but not mutual funds.

Let’s say, the hope behind shorting a stock is that the stock price will decline or that the company will go bankrupt. Of course, it will lead to total ruin for the equity owners.

What short seller do?

The short seller is buying the stock back at a much lower price. Then, replaces the borrowed shares, and takes the difference.

A condition of a short sale transaction is that the short seller promises to replace the borrowed stock at some point in the future. The dividend replacement pays out of his own pocket in order to cover the dividend income that is no longer available on the original shares.

In simple words, when you short sell, your broker is lending you stock to sell in the future. The stock can come from the brokerage firm’s inventory, a customer of the firm, or from another brokerage firm. The shares are sold and the proceeds are added to your account.

Shorting Stock - Explanation

image source: www.marketindex

When you are ready to close your short position, you must buy the same number of shares at the current price at the time and return them to your broker. Your profit or your loss is the difference between the price you initially sold at and the price you bought them for.

Shorting stock includes some necessary steps.

One of them is a short-term strategy.

Selling short is primarily designed for short-term opportunities in stocks or investments that you expect to decline in worth.

The primary risk of shorting a stock is that it will actually increase in value, resulting in a loss. The potential price valuing of a stock is theoretically unlimited. So, therefore, there is no limitation to the potential loss of a short position.

Also, shorting stocks involves margin. Yes, a short seller will be subject to a margin call in the event the security price moves higher. A margin call will require a short seller to deposit extra funds into the account to fill the original margin balance.

In some cases, the SEC has restrictions on who can sell short, which securities can be shorted, and the way in which securities can be sold short.

There are notable limitations to shorting low-priced stocks, for example.

Shorting stock is not for the amateur

Due to the possible large losses that short selling generate, brokerages decrease this method to margin accounts. While opposite, brokers prohibit the practice if you use a cash account with no margin.

You need to open a cash account if you want to hold away short sellers from borrowing your shares without your approval. This is usually good practice, anyway. It also goes a long way toward reducing the risk of your brokerage firm using your shares as collateral for their own financial dealings.

The combination of unlimited losses and a margin account can be extraordinarily catastrophic for amateur investors and speculators. Especially for those who don’t fully understand the risk they face whenever they place a short position without some protection.

The importance of timing

Shorting stock is possible because assets can become overvalued. For instance, recall the housing bubble that existed before the financial crisis in 2008. Housing costs increased, and when the bubble exploded a sharpened correction took place.

Likewise, financial securities that trade regularly, such as stocks, can become overvalued or undervalued.

The key to shorting the stock is identifying which securities may be overvalued. Also, when they might decline, and when they could expand.

How long to stay in a short position?

The traders may enter and exit a short sale on the same day.  Or they might continue in the position for several days or weeks. It depends on the strategy and how security is performing. Timing is particularly important to short selling.  But the potential impact of tax treatment is important too. So, we have to say, this is a strategy that requires practice and study.

Is there any tool for shorting the stock

Shorting stock can be used in a strategy that requests identifying winners and losers within a  sector.

For example, a trader might choose to go long a cloth maker in the cloth industry that they expect to take market share. But, at the same time, goes short another clothmaker that might decrease.

Shorting may also be used to hedge existing long positions. Assume an investor holds stocks of XYZ company and they expect it to decrease over the next several months. But do not want to sell the stock. That investor could hedge the long position by shorting XYZ company while it is expected to weaken. And close the short position when the stock is supposed to grow.

The bottom line

But you have to be very careful.

The process of shorting a stock is quite simple. But, yet this is not a strategy for amateur traders. Only the expert investors who know the potential implications should consider shorting.

Waste your time. Not your money.

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