Would you ever listed a car for sale that you don't even own? What about a piece of property or even a house? Well, that's what short selling is; selling something you don't own.
And surprisingly, it's not illegal, but it isn't without its risks. Keep reading for the pros and cons of short selling: What you need to know.
What Is Short Selling?
Short selling is a technique used by traders who try to profit from the falling price of a stock. In fact, short selling can be risky as it involves precisely timing the market and goes against the overall direction market direction. For these reasons, short selling is a very difficult feat.
Here's How Short Selling Works
Let's assume you believe a company is going to fall in price because sales are slowing and rumors have it, earnings will drop. Unfortunately, you don't own shares because quite frankly, you can't afford them.
You can, however, borrow them. It's akin to renting something, you get to use it, but you need to return it.
In our case, we borrow the shares from our broker. Our broker then borrows the shares from someone who owns them with the promise that they will return them later.
Based on your research, you borrow or sell short 100 shares at the current market price. You hope that the price of the shares tank and you can then repurchase them at the lower price.
In the trading world, we call this "covering" your short position. You then return them to your broker, who returns them to the lender.
How Much Can You Make Short Selling
To calculate your profit, you simply take the difference between the price at which you sold the stock and your cost to repurchase it.
Oh, and don't forget the cost of commissions and expenses for borrowing the stock in the first place.
But what if your analysis is wrong and the price of the shares increases? In this scenario, your potential losses are unlimited.
At some point, you have to replace the 100 shares you sold or "borrowed." In that case, your losses can mount without limit until you cover your short position.
Here Are a Few Reasons Why Short Selling Makes Sense
You can hedge your bets. For those traders who are worried about losing money, they can open up a short position. Likewise, this helps them to keep the stock price that is already there at the time. You then don't have to worry as much about dropping prices because you get an increase if that happens.
You can capitalize on overpriced/overvalued companies. We have a few different scenarios you can capitalize on. First, you think that a stock price is worth more than you think. Secondly, you may think somethings going to happen to decrease the value of the stock. With both of these scenarios, you can use a short position.
Companies Short-Sellers Target
- Small-cap companies that are pumped up by momentum traders, especially companies that are difficult to value.
- Look for companies with P/E ratios much higher than their growth rates can justified.
- Companies with weak financials like a bad balance sheet or negative cash flow, etc.
- Companies that rely too heavily on one product
Here's Where You May Run Into Trouble Short Selling
Especially for beginners, short selling is a risky strategy. With this in mind, you need to be fully aware of the different risks of short selling.
Unlimited Loss Potential. For starters, someone who has bought actual stock can only lose 100% of their capital if the stock tanks to $0.00. However, someone who has shorted stock can lose more than 100% of their original investment if the price skyrockets. The risk to you is if you don't have a stop in place. Because there is no ceiling for a stock's price; it can rise to infinity and beyond.
Margin Trading. Shorting is also referred to as margin trading. Essentially you borrow money from the brokerage firm using your investment as collateral. Akin to going long on margin, it's easy for losses to get out of control. You must also meet the minimum maintenance requirement of 25%. And unfortunately, if your account drops below this, you'll be subject to a margin call and forced to cough up the cash or liquidate your position.
The Dreaded Short Squeeze. A stock that's actively shorted with a high short float and days to cover ratio is ripe for experiencing a short squeeze. A short squeeze happens when a stock begins to rise in price for whatever reason. Predictably, short-sellers cover their trades by repurchasing their short positions, which triggers a feedback loop. The increasing demand attracts more buyers, which pushes the stock higher. In turn, this causes even more short-sellers to buy back or cover their positions.
Short selling is a great way to make significant profits, but it's not for the inexperienced or faint of heart. That's because there's a whole lot that can go wrong when it comes to a short sale.
The most important thing that you can do is make sure that you've done your homework. This type of trading is a very complicated game, and you don't want to find yourself on the wrong side of a trade.
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