Short selling
( http://www.investopedia.com/university/shortselling/ )
· What is Short selling
Short selling is the selling of a stock that the seller doesn't own. More specifically, a short sale is the sale of a security that isn't owned by the seller, but that is promised to be delivered.
· The Transaction
Suppose that, after hours of painstaking research and analysis, you decide that company XYZ is dead in the water. The stock is currently trading at $65, but you predict it will trade much lower in the coming months. In order to capitalize on the decline, you decide to short sell shares of XYZ stock. Let's take a look at how this transaction would unfold.
Step 1: Set up a margin account.
Step 2: Place your order by calling up the broker or entering the trade online.
Step 3: The broker, depending on availability, borrows the shares.
You should also be mindful of the margin rules and know that fees and charges can apply. For instance, if the stock has a dividend, you need to pay the person or firm making that loan.
Step 4: The broker sells the shares in the open market. The profits of the sale are then put into your margin account.
One of two things can happen in the coming months:
The Stock Price Sinks (stock goes to $40) | |
Borrowed 100 shares of XYZ at $65 | $6,500 |
Bought Back 100 shares of XYZ at $40 | -$4,000 |
Your Profit | $2,500 |
The Stock Price Rises (stock goes to $90) | |
Borrowed 100 shares of XYZ at $65 | $6,500 |
Bought Back 100 shares of XYZ at $90 | -$9,000 |
Your Profit | -$2,500 |
· The Risks
Ø Short selling is a gamble.
History has shown that, in general, stocks have an upward drift. What this means is that shorting is betting against the overall direction of the market.
Ø Losses can be infinite.
When you short sell, your losses can be infinite. A short sale loses when the stock price rises and a stock is (theoretically, at least) not limited in how high it can go.
Ø Shorting stocks involves using borrowed money.
This is known as margin trading. Just as when you go long on margin, it's easy for losses to get out of hand because you must meet the minimum maintenance requirement of 25%. If your account slips below this, you'll be subject to a margin call, and you'll be forced to put in more cash or liquidate your position.
Ø Short squeezes can wring the profit out of your investment.
When stock prices go up short seller losses get higher, as sellers rush to buy the stock to cover their positions. This rush creates a high demand for the stock quickly driving up the price even further. This phenomenon is known as a short squeeze. Usually, news in the market will trigger a short squeeze, but sometimes traders who notice a large number of shorts in a stock will attempt to induce one. This is why it's not a good idea to short a stock with high short interest. A short squeeze is a great way to lose a lot of money extremely fast.
Ø Even if you're right, it could be at the wrong time.
The final and largest complication is being right too soon. Even though a company is overvalued, it could conceivably take a while to come back down. In the meantime, you are vulnerable to interest, margin calls and being called away. Academics and traders alike have tried for years to come up with explanations as to why a stock's market price varies from its intrinsic value. They have yet to come up with a model that works all the time, and probably never will.
