Short selling is considered an advanced trading technique that contradicts the goal of most investors – finding the best stock to buy.
Short Selling
Short selling occurs when an investor borrows stocks that are declining in price to sell them and then buys them back at a profit when their prices drop further. The profit from short selling is the difference between the higher selling price and the lower buying price.
Short Sale
This is how short selling works. Let’s assume you believe the market has overpriced the stock of “Amalgamated Kumquats” and that it is set for a significant decline.
You contact your broker and tell them you want to “short sell” 300 shares of “Amalgamated Kumquats.” Your broker will require you to have a margin account, meaning you need to meet their credit and deposit requirements. Your broker will sell 300 shares of “Amalgamated Kumquats” from their inventory or “borrow” the shares from another client or broker.
From 1937 until 2007, short sales could only be executed under an “ uptick” rule, meaning the short sale had to occur at a price higher than the last trade. The idea was to prevent a group of short sellers from joining a declining stock and driving the price down further. Whether the uptick rule was effective is debatable.
In 2007, the U.S. Securities and Exchange Commission abolished the uptick rule, and short selling could occur at any time. After the financial crisis, some pointed to the unrestricted short selling of stocks as a partial cause of the crisis, although the case for it was not clear. Instead of restoring the uptick rule, the SEC in 2010 created an alternative uptick rule, which imposes the uptick rule on the day when a stock’s price drops more than 10% from the previous closing and the following day.
Your broker holds money from the sale in your account to protect the original owner of the shares. You may not earn interest on this money, and if the stock pays dividends during this time, you will owe them to the owner.
How It Works
If the stock price drops the way you anticipated, you can buy 300 shares at the lower price and replace the borrowed shares. The difference between the sale price of the stock and its purchase price is your profit. For example:
You sell 300 shares at $45 per share. Your broker deposits $13,500 in your account. After two weeks, the price drops to $35 per share. Your broker goes to “cover” the short sale or buy 300 shares to replace those you sold.
Your broker buys 300 shares at $35 per share and deducts $10,500 from your account to pay for the shares. The broker replaces the borrowed shares, and you have a profit of $3,000 ($13,500 – $10,500 = $3,000).
Thanks to your correct prediction, you make a profit of $3,000 in a very short time. However, what happens if you are wrong? This is the dark side of short selling.
The same short selling scenario: you sell 300 shares at $45 for $13,500. However, instead of declining as reason and logic suggest, before you know it, the stock price rises to $55 per share. You decide to cut your losses and cover the short sale by buying the shares at $55 per share for $16,500. Due to margin requirements, your account has enough assets to cover the $3,000 loss, although you may need to liquidate some assets to avoid holding shares using margin.
If
The stock price increase was much worse, as the net liquidity value of your account drops below your broker’s margin rules, meaning you will have to deposit more money or cover the short sale by buying the stock. If not, the broker will buy the stock to protect themselves from potential losses if your account goes negative and declares bankruptcy.
What are the risks?
As you can see, short selling can provide quick profits, but it also carries high risks. Using someone else’s shares to make money presents an opportunity for extraordinary profits and the potential for a financial disaster. Here are some risks:
- You do not have full control over short selling. Under adverse conditions, where the stock price rises significantly, the broker may force you to add more money or buy the stock outright without your consent. If the price rises, you could lose money. If the broker doesn’t have a margin desk, the losses may be unlimited. If a large number of short sellers attempt to cover their positions in a stock, they may drive the price up quickly. This is called a short squeeze. A short squeeze can also happen if those who own the shares transfer them from a margin account to a cash account, reducing the shares available for borrowing, and brokers may be compelled to buy shares that have been sold short on behalf of account holders. If the shares are hard to borrow, short sellers may have to pay interest to borrow the shares, plus any dividends distributed by the shares. The profits and losses from short selling are all short-term, except for short sales that are “constructive sales” of already owned long positions. This means your tax rate will be higher than it would be on long-term gains.
- You are betting against a market history that tends to rise. This is certainly not true for individual stocks; however, a strong bull market may drive up the prices of marginal stocks. There is no way to accurately predict when stocks will decline (or rise, for example). The market value of a stock does not always align with its fundamentals. Additionally, it becomes challenging to predict when a stock will correct. Long-term investors may wait for the stock price to rise. But short sellers typically do not have that luxury.
How to choose stocks for short selling
How do you choose stocks for short selling? It’s easier to tell you what not to do:
- Absurd valuations are not a sufficient reason to short sell. Jim Cramer once said something like, “An absurd price is like infinity. Doubling infinity is still infinity. Doubling the absurd price is still absurd.” As Keynes apparently said, “The market can remain irrational longer than you can remain solvent.” Do not sell into strong upward price movements. Wait for the momentum to falter. Do not sell to zero, even if it were possible. Additionally, if a stock is delisted, it can become extremely difficult to cover your short position. Avoid crowded short stocks that are widely talked about. Besides the fact that it’s hard to borrow shares in these instances, these are the most probable scenarios for a short squeeze to occur.
- Signs that a company may be worthy of short selling include an arrogant management team, poor accounting, weak fundamentals, and potential implosion, etc. Make sure you have better insight than all of the professionals who own the shares. This is very difficult to achieve.
Conclusion
Short selling
Short selling is not suitable for new investors. In fact, many believe it is considered speculation rather than investing. Don’t be lured by the possibility of easy money, as it usually doesn’t exist. The potential for loss is greater than the potential for success. Finally, remember the old saying about short selling: “Whoever sells what he does not own must return it or go to jail.”
Source: https://www.thebalancemoney.com/short-selling-stocks-not-for-the-faint-hearted-3140549
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