What Is Short Selling and How Does It Work
Short selling is the practice of selling a borrowed security to buy it back when the price declines. It is not the best strategy for novice investors because of the huge risk of loss.
How Short Selling Works
This is a short-term strategy because of factors such as inflation. Traders buy securities such as stock from a company or through a stock broker. Most traders use the services of seasoned brokers and open a trading account such as margin or cash account. Going short means selling a security or a futures contract or writing on option on the belief that the price will decline. By the same token, going long refers to buying a security that is expected to increase in price. The trader doesn’t own the security. He actually borrows it from a stock broker. The trader will buy the same amount of stock to close the short and return it to the brokerage firm. Traders buy back securities when the price declines and make a profit. The opposite happens when the price goes up – they lose money.
Mr. Peterson expects that the stock of the DRS Corporation will decline in price. He contacts his broker to borrow 200 shares. The current per share price is $20. The cash inflow is $4,000 after selling short. In three weeks, the price of stock goes down. Mr. Peterson buys back stock for $15 per share. He spends a total of $3,000 to repurchase the stock. The profit is $1,000 or $4,000 from the initial sale minus $3,000 to buy back the shares. If stock prices increase to $23, however, Mr. Peterson would have lost $600 ($4,000 from the initial sale minus $4,600 to buy back the shares). He will lose even more if the price of shares increases to $25 or $30. The same is true for price declines. The lower the price of stock, the larger the profit.
Reasons and Benefits of Short Selling
There are different reasons to sell short, one being to protect your portfolio or certain investment instruments. Traders choose to sell short when they hold many long positions. This is one way to hedge risk. Another reason is to make money in a bearish market when the value of stock is expected to decline. One problem with this trading strategy is that it involves unlimited risk. The price of stock could keep going up, and there is no limit to maximum loss. Another problem is that traders owe any rights and dividends that go with stock. This is how stock brokers benefit. Find out more about the dividends that your stock is paying.
Make Money Short Selling
Obviously, this is the main goal – make money short selling. One way to do this is to use negative return momentum. Whether you will make money, however, depends on market conditions. Whether in down or up markets, look for new opportunities and ways to minimize risk and protect and maximize your profits. Timing is a very important factor when buying and selling shares. With timing in mind, this can be a successful strategy in bear markets. A bear market typically begins every 3.6 years and lasts for about a year and a half. Gains mostly come from markets moving in a certain direction. It doesn’t make sense to short into a bull market unless you find a company near bankruptcy before other traders or the timing is really good. Most of the time, you will lose money. Keep in mind that some types of stock cannot be shorted. This is the case with penny stock below $5. In addition, shares with a small float and stock that is thinly traded cannot be shorted.
Types of Short Sellers
The main players include risk arbitrageurs, hedgers, market makers, and hedge funds. They use different long short strategies and specialize in instruments such as convertible bonds, futures and options, and other equity derivatives. While speculation is to blame for declining stock prices, these players actually contribute to market liquidity. This means that the cost of transactions also goes down. Liquid stock increases in price as a result because more traders are ready to invest. Market participants may be unwilling to sell stock when prices go down, even if stock is overvalued. Short sellers step in to counteract irrational behavior. While they move contrary to market direction, the ultimate goal is to profit from price and market fluctuations. At the same time, if a large number of market participants choose to sell short, this can have a huge impact on stock prices. This is the main reason why governments have enacted bans and restrictions on short sales in different periods.
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