When markets drop, most investors do one of two things: either panic and sell their holdings or hide and hope that their stocks come back someday. But what if you could not only protect your capital in market downturns but also make money? Welcome to the pros and cons of short selling or shorting a stock as it is known. This strategy is widely overlooked by investors and financial advisors who do not know how to use it properly. In this article, we will dive deeper into shorting a stock and examine the benefits as well as risks involved.
What is Shorting a Stock?
Short selling or shorting a stock is a strategy that traders could employ when they believe that the prices of the stock are too high and think they are going to drop. We are used to the mantra of buy low, sell high as a way to strategize in the markets. This is no different except that traders sell first and buy later. To short sell, traders would borrow shares of stock from their broker and sell them. The money received for selling the borrowed shares is kept in escrow until the position is closed. To close the position, traders will have to buy the same amount of shares that were borrowed in order to give them back to the broker.
Profits and Losses
The idea behind shorting a stock is to profit from a drop in the price of a stock. For example, a trader borrows 100 shares of a stock and then sells them at a price of $45 per share. She would collect $4500 but owe the broker 100 shares. If the price drops to $38 per share, she can close the position by buying 100 shares at $38. Since buying the shares only cost $3800, she would get to keep the $700 after she returns the borrowed shares back to her broker.
But what happens if the trader is wrong and the stock price rises instead? He must still replace the borrowed shares at some point. So, if he sold 100 shares short at $45 like the above example but the price rose to $47, it would now require them to pay $4700 to buy the stock back and close the position. This would result in a $200 loss in his account. The profits in shorting are limited to the price at which a trader shorts down to zero as that is as low as prices can go. Theoretically, the potential losses in shorting are unlimited as there is no upward limit for the price of a stock. In reality, though, investors and traders can place stop losses to limit the amount of risk they are willing to take in a short.
Why Short a Stock?
In contrast to buy and hold or buy and panic sell which both result sustaining financial losses in the market, shorting allows traders and investors to benefit from downward movements in the stock market. If a trader only buys stocks, his profitability is limited to less than 50% of the market movement. Stock prices can move up, down and sideways. When traders buy stocks, they can make money when prices rise and lose when they drop. The opposite is true for shorting stocks where, instead, traders profit from prices dropping and lose when they rise. Anyone who has been active in the stock market can tell you that on average prices drop faster than they rise. This means when you short, you can typically gain faster and lose slower.
Who Can Short?
Any trader or investor with a margin account can enter a short position. Unfortunately, IRAs are cash accounts, not margin, and therefore shorting is not allowed in them. Good news though, there are inverse ETFs and options that are available in cash accounts to make the right moves when prices drop.
It is fairly easy for any individual to open a margin account so that they can sell stocks short. Brokers will set aside a certain number of shares from their inventory or from other customer accounts that are available to be borrowed for shorting. There is no time limit for when the shares must be returned. Some traders will go short and close the position in the same day. Investors can short a stock and stay short for weeks or even months. The only difference is that when you borrow the shares overnight, you will have to pay interest on the value of the shares you borrowed. Day traders who replace the shares the same day they borrowed them do not have to pay interest.
Shorting a stock is a simple technique that when understood and applied correctly can be used by investors and traders to benefit from stock prices dropping. To do it correctly, a trader must first recognize overpriced stocks that are likely to drop in price. A Trader then needs to have the skill to identify the proper entry and exit prices as well as where to place her protective stop loss. Be prepared for market crashes and even turndowns. Begin to learn how to make the right moves in the stock market regardless of price direction with an education in shorting.