Do You Understand Short Selling?

"Short Selling" is the process of selling a stock first, without actually owning the stock in the first place, at least from an individual trader or investors point of view.

Individual investors and traders, Hedge Funds, and large Institutional Investment firms are all involved with shorting stocks on a regular basis.

When selling a stock short, your intention is to sell the stock first and buy the stock at a later time, called "buying back" or "covering your position" or "buy to close", at a lower price than you initially sold the stock for. This is in contrast to a normal investor transaction when you buy a stock first, and then sell it at a later time.

Why Would You Want To Do This?

Take for example a company called XYZ that is trading at $50.00 per share. The company has shown consistent profits and growth over the last 5-10 years. The company knows exactly what type of assets they own, or "on their balance sheets", and they know the value of these assets can be calculated in different ways to produce different amounts of profits or losses when they report their earnings to the public.

In order to keep the company stock price rising, each quarter when they report their earnings they choose to calculate the value of these assets using a method that shows the highest value.

Over the next few quarters, the value of these assets are drastically reduced because of a slowing economy and other things beyond their control.

One day a news report comes out that the management of the company has not been reporting the value of the company assets, we'll call these "Mortgage Backed Securities" in this case, accurately. After these news reports come out, if you own the stock you would probably sell your shares.

If you did not own the stock, would you want to buy this particular stock? Of course not. This is a situation where you would want to start "Short Selling", or short the stock.

So the times you would want to be "Short Selling" would be when you think a stock price is going down in the future. This could be for reasons as I said in my example above, or many other reasons that show negative pressures towards a company such as:

  • Slowing Sales
  • Company Scandal
  • Poor Management
  • A Misleading Management
  • Macroeconomic Conditions
  • Microeconomic Conditions
  • Possible bankruptcy

How Do I Short Stocks?

When you want to start shorting stocks, you must first have a Margin account setup. The reason is that when you sell the stock first, you are selling a stock that you do not own and promising that you will produce the stock at a later time.

Having a Margin account is like having a credit line from the bank and the amount is determined by your account balance multiplied according to specific regulations.

In order to be able to short a stock, the stock must also be available to borrow ahead of time by your broker, so that you can sell it in advance.

The steps to short stocks are the opposite of when you buy stocks. First you place an order to sell shares, and once your trade is executed, you then have to "buy the shares back", or "cover" at a later time or date.

How Do I Make Profits Shorting Stocks?

In order to make a profit when short selling, you must "buy back your shares" at a lower price than what you initially sold them for.

Example:

  1. You place an order to "sell short" 100 shares of XYZ stock at $50 per share.
  2. XYZ drops down to $40 per share.
  3. You place an order to "Buy To Cover" 100 shares at $40.00
  4. This results in a profit of $10 per share or 25% before commissions.
Action Result To Account
Sell Short 100 Shares x $50 per share +$5,000 credited to your account
Buy To Cover 100 shares x $40 per share -$4,000 Debited from your account
Zero shares left in account +$1,000 Profit

Can I Lose Money?

You sure can. Just like any other investment or trade, you can lose money short selling as well.

You can lose money when you are buying a stock and selling it later, or selling the stock short first and buying it back at a later time.

One of the differences is that when you buy a stock, you can only lose as much as you paid for it. For example, when you pay $10 for a share of stock, you can only lose $10.

When you sell a stock short for $10, you can lose an infinite amount of money if you don't watch it closely. For example, if you sell a stock short at $10 and the stock rises to $100 before you buy it back, you now lost $90 per share. If you don't buy it back and the price keeps rising, your losses are unlimited.

The way around this is to make sure you use "Stop Losses" and proper "Position Sizing". If you have rules in place and follow your rules, you can control the amount of losses when they do occur.

Is Short Selling A Bad Thing?

Short selling is a normal function of the stock market. Just like anything else though, there are people that abuse things and as a result, the media and government take step to restrict these abuses.

As of right now in September of 2008, governments and government organizations are banning short selling for new short sales of some or all stocks.

On the news today, this is said to be being done to prevent investors from deliberately driving down a stock price for their own personal financial benefit. This doesn't make sense. What about investors who buy a stock deliberately to raise a stock price for their own personal benefit?

If short selling is banned, there are still other ways to profit from down trending stocks, such as buying "PUT Options" and buying certain ETF Funds.

I agree that steps have to be taken to combat abuse, but not short selling in general.

What Else Do I Need To Know?

One of the things that is said to have been abused in the past is being allowed to short without regard to the previous direction of price movement. There used to be a rule that you could not short a stock unless the previous trade in the stock was at a higher price than the price before.

This rule was called the "Uptick Rule". To find out more information about this, read my other page here: Uptick Rule

The other thing that has been abused is what is called "Naked Short Selling". Naked Short Selling is the process of shorting shares, or selling shares, that are not available to be borrowed and bought back at a later time. This is currently illegal, but not or not able to be, tracked and controlled effectively.

Resulting Strategy

There will always be companies that are profitable and have rising stock prices, as well as ones that are doing poorly and have declining stock prices.

As an investor or trader, you should learn about Short Selling to be aware of one of the options that are available to take advantage of stocks that are declining in value.




For more related information on this topic, take a look at the following pages on this website also:

Return To "Short Selling Stocks"


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