What is short selling? In the world of investing, short-sellers are often frowned upon for the risky strategies they employ. But in reality, they are just using market trends to their advantage just like everybody else.
Essentially, they profit the most when the market is down—that is, when stock prices decline and long-term investors are in the red. This, of course, comes with many risks, but to understand them, we must first define what a short actually is.
Note: The investment advice offered may not be suitable for all investors. As everyone has different ideas on how they would like to invest their own wealth, you should always seek an independent financial advisor to get tailored advice for your own situation, especially if you have any doubts as to the merits of an investment.
Defining a short
A "short" is a sale intended to make a profit when stocks fall in value. Here's how it works: you borrow shares of an overvalued stock from a broker, who then immediately sells those stocks on the market. The money that is made from those sales is then lent to you (since you never actually owned the shares that were sold). Later on, as the stock value continues to drop, you buy back those shares at a lower price, return them to the broker, and keep the difference as your profit.
For example, say Stock A is trading at $100, but you believe that it is overpriced by $50.
You would then borrow 100 shares of Stock A from your broker, who would then sell them at $100 each for a total of $10,000. In a few months, when the price of Stock A falls to $50 as you predicted, you can buy back the 100 shares at $50 each for a total of $5,000. You return the 100 shares to your broker while pocketing the other $5,000 profit, minus commissions and interest on the initial loan.
It seems relatively straight-forward, but things can really take a turn for the worse if you mispredict. If in the previous example the price of Stock A rose to $300 instead of falling to $50, you would have to buy the 100 shares back at a much higher price—$30,000 to be exact—meaning you would lose $20,000 plus commissions and interest.
It's important to keep in mind that while the maximum gain you can get from a short sale is 100% (when a stock price goes to $0), the maximum losses are, well, technically infinite.
Shorting a stock
To short a stock, you must first make sure you're set up for a margin account with your broker, which will allow you to borrow shares. Go to your broker site, enter the ticker, then use the command "sell to open" or "sell short." Keep in mind that not all stocks are available for shorting.
Once you make the trade, you'll be given a lent payment as a negative number in your account. When the stock goes down, you can buy it back using the "buy to close" command. The difference will be left in your account as your profit.
If the stock price increases to a higher share price, you will eventually need to buy it back at a higher price and just take the loss. You must make sure you have enough money in case this happens. Selling short is typically a short-term strategy, so it is not the best idea to wait for years in hopes that changes in the market will offset your losses. In fact, waiting too long may worsen your losses and wipe you out entirely, so it's important to stay on top of things.
Some things to consider when selling short: First, you will have to use up any dividends you may receive when you borrow shares. Second, there will be an interest on the loan that you will need to pay once you've borrowed the shares, so that cost should be factored into your bottom-line projections. Lastly, beware of the short squeeze—if the stock price goes up, your broker can decide to force you out of your short position should it need to give the shares back to the owner.
All in all, short selling is important for providing information about the market, particularly which companies are underperforming. However, finding the right companies to short can be tricky because the market is generally on a long-term upward trend. If you are looking to short, look for overvalued companies with considerable debt loads, low profits, few competitive advantages, and shaky management. To succeed with shorting, you must get into a frame of mind that is opposite of most stock investors—find opportunities with limited upside risk and large downside potential.