| Selling
short, short selling, or “shorting” is an investment
strategy where an investor speculates that a stock will go
down in value. It is the sale of a stock that you do not own.
When you sell short a stock, your broker will lend you the
stock from either the brokerages own inventory, another of
the firm’s clients, or from another brokerage firm altogether.
The stock is sold immediately and the proceeds are put into
your account. Eventually you must buy back the same number
of shares or “close” the short and return the
stock to the broker. When selling short you hope the stock
price drops so you can buy back the stock at a lower price
and make a profit on the difference. On the contrary, if the
stock price rises you must buy back at a higher price and
consequentially lose money.
For example, an investor believes that there will be a decline
in the stock price of Company A. Company A is trading at $10 a share, so the investor borrows shares of Company A stock at $10 a share
and immediately sells them in a short sale. Later, Company A's stock price declines to $5 a share, and the investor buys shares back on the open market
to replace the borrowed shares. Since the price is lower, the investor profits on the difference -- in this case $5 a share (minus transaction costs such as commissions and fees).
However, if the price goes up from the original price, the investor loses money. Unlike a traditional long position — when risk is limited to the amount invested — shorting a stock
leaves an investor open to the possibility of unlimited losses, since a stock can theoretically keep rising indefinitely.
You
can “sit on a stock” for a period of time in hopes
it will drop in price to where you desire, but eventually
you will be forced to give the broker back the stock “cover”.
Note: since you are technically being lent the stock when
shorting, you must open a margin account and adhere to the
rules of margin
trading.
Important
points to consider before selling short a stock:
Your
gains are always limited, but your losses are almost infinite.
A best case scenario for a short seller is that you buy a
stock, the company files for bankruptcy, and the shares then
have virtually no value. You are then able to buy the stock
back for next to nothing and earn almost a 100% return on
your investment “ROI”.
On
the other hand, your potential losses have no limit. If you
sell short a stock and it doubles in value, you lose 100%;
if it triples you lose 200%; and so forth.
The
stock market goes up more than it goes down.
On average the stock market (national exchanges) returns 10%
or more per year. Share prices go up two to three times as
often as they go down. That’s why a bull market tends
to last for many years while a bear market usually lasts only
a year or so. Note: the OTC market is much more volatile and
most OTC companies stocks are less stable and don’t
move with the market as frequently.
Brokerages
tend to “rip off” small investors who sell short.
When you borrow money to buy stock on a margin, you receive
dividends on the shares buy have to pay interest on the loan.
It would sound reasonable to assume that when you sell borrowed
stock, the reverse would apply: you would have to pay dividends
due on the borrowed stock but receive interest on the cash
proceeds from selling the shares but that is not the case. You are required
to pay the dividends, but unless you’re a big professional
investor, you do not get any interest
on the cash proceeds resulting from the stock sale.
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