There are some well known and popular trading techniques that pop in day trading and Short Selling Stock is one of those techniques. But what is Short Selling Stock? How do you do it? We’re going to get into that right now, don’t you worry.
Short selling a stock is a technique that you’ll speculators, gamblers, hedge funds and individual investors take part in. It’s a technique that’s used by investors who aren’t afraid of substantial capital loss. Short selling a stock, also known as shorting, involves the sale of a stock that the seller does not own or shares that the seller has taken on loan from a broker. This technique can even be done with other securities, like options. So it’s easy to see why it’s such a riskier technique in that explanation alone. But, let’s dive even deeper.
So what’s the motivation for short selling a stock? Well, if an investor sees that a stock is projected to drop in price they can sell the stock on one day, then buy it back at a later date when it’s lower in price. If the investor pulls off this technique, they can make a profit consisting of the difference between the sell and buy prices. Some traders use short selling for the speculation of it while others use it to hedge (which is an investment to reduce the risk of adverse movements in an asset), or protect their downside risk if they have a long position.
Now that we have simplified what short selling is and why a trader would do it, let’s break down what short selling basically looks like in practice. So, say that you believe the price of a stock is largely overvalued and believe that it’s headed for a crash soon. You believe that this is going to happen so much, either through heavy research or a true gut feeling, that you decide to borrow 10 shares of said stock from your broker. You would then sell those shares in the hopes that you can buy them back at a later date for a lower price, return those shares to your broker and pocket the difference you made from this process.
So if you sell the 10 borrowed shares at $50 each, you’re coming out the other side with $500 in your pocket. But let’s not forget that you’re also paying a small commission and depending upon timing, might also have to pay dividends to the buyer of your shares. It’s important to take in the reality of the situation, after all. But, if we ignored all the other things (that’s not recommended, factor it in when considering using this technique), you now have $500. After making that nice $500 you now have an obligation to purchase and return those 10 shares of stock, at some point in the future. If that stock goes up above $50 price, you’re losing money. The reason that you’ll be losing money is because you’ll have to pay a higher price to repurchase the shares and return them to the broker’s account. Hence why it’s a risky technique and not recommended for those who can’t afford the potential loss in capital.
Where this can go very wrong is if the stock jumped to $75 a share, then you’d have to buy back the 10 shares that you owe back to the brokerage, meaning you’d have to spend $750 to buy those shares back. Yes you still have the $500 you made from selling the shares but you ended up losing $250. Which is not a pretty amount of money to part with, no matter how you look at it. Though on the other hand, if the stock drops to $25, you can buy the stock back for $250 instead of $500, so you make $250 in profit, minus commissions.
Speaking of being careful, let’s talk about the risks of short selling. Mainly that when you short sell, you’re taking an incredible financial risk every time you do it. In some cases, when investors and traders can see that a stock has a large short interest, meaning when a big percentage of its available shares have been shorted by speculators, they can take the opportunity to drive up the stock price. Thus forcing speculators with short positions to buy back the shares before the price skyrockets anymore. This is a way to exert an amount of control over the stock price before speculation can cause huge losses.
Another thing to keep in mind is that you should never assume that you can repurchase a stock when you want and at the price that you want. This isn’t a “have it your way” kind of situation, you see. The market for that given stock has to be there. A multitude of things can go wrong, such as no one selling the stock, too many buyers, or even panic buyers popping up due to other short sellers attempting to close out their positions as their money starts to drop. If these occurrences happen, you stand to take on some major losses.
There’s no guarantee that you’ll be able to buy or sell shares on the way up or down. Prices can even instantaneously reset, with the bid or asking prices jumping higher in what seems like a snap of the fingers. Also keep in mind that the risk of losses when it comes to short selling is infinite, in theory. That’s because the stock price could rise with no limit, which is a frightening thought for any investor. This is why this technique is most useful and recommended for seasoned traders. Traders who understand and are prepared for the potential large risks and losses that can come from short selling. In fact, shorting a stock is subject to it’s own set of rules. One of these rules is that there are limitations to shorting a penny stock. Another rule is that before shorting a stock, the last trade must be an uptick, or small price increase.
As always, the main advice when it comes to any trading technique is that you should be prepared in case the risk becomes higher than the potential reward and know just exactly how things can go bad so that you know what to do and how to cushion the fall if/when they do. This is advice that goes very well when it comes to shorting.