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What Is Shorting Stock And What Are The Basics Of How To Do It?

What Is Shorting Stock And What Are The Basics Of How To Do It?

Investors, especially those of us who are new, hear a lot of different financial terms when we get started. From buying on margin to shorting stock to exchange traded funds. The different types of investment vehicles and tools seem endless and are often confusing. Shorting a stock is one of the tools available which if used wisely can lead to significant returns but is also riskier than more typical investment strategies. What exactly is shorting a stock, how can an investor short and what are the risk associated with this type of activity?

Shorting a Stock

Shorting a stock, also known technically as short selling, means selling a stock which you currently do not own in the hopes that it decreases in value. Many investors, after much evaluation and analysis, will determine that a stock may be overvalued or susceptible to a price correction resulting from lowed earnings expectations or adverse information being made public. Investors looking to short a stock will use their brokerage firm to bet against a stock expecting it to fall. At that point they will buy the same number of shares on the open market and repay the temporary loan from their brokerage firm.

You might be asking yourself how can you sell something you don't own. That's a great question and it's important to understand because it has inherent risks and trust involved. Shorting stocks requires the brokerage firm's permission as they will be the one to provide the shares from their portfolio or borrow shares from another shareholder. Unlike owning a stock outright, short sales normally have a time limit at which point the position must be reconciled. To balance the transaction, the investor must purchase the shares on the open market to "cover" those shares which were initially borrowed.

How to Short a Stock

Once you have permission from your brokerage firm, you can initiate a short sale stock trade hoping the price of the stock goes down. An example of how a short sale might work would be to purchase 1,000 shares of ABC Co. at $10 per share. Since you do not currently own these shares you will need to buy them at some point in the future. In order to profit you will need to buy them at a price lower than $10 per share. If four months goes by and the stock price of ABC Co. is $7 per share you can purchase 1,000 shares on the open market at that price. At this point you would sell the shares back to the brokerage firm for $10 per share netting a difference of $3,000 in profit minus fees and commissions.

Shorting a stock is a excellent way to participate in the market for a single company and profiting from adverse market forces. Most investment advice revolves around a buy-and-hold strategy. This is where a stock is purchased in a good company with long-term growth and at some point in the future it is sold for a profit. But investors know that not every company is created equal and some stocks decrease for a multitude of reasons. Instead of seeing a stock run-up from $10 to $90 a share and lamenting missing the boat, you may be thinking the stock has gotten ahead of itself and is due for a correction. This is a perfect example of when to initiate a short sale in the hopes of the stock dropping in price.

Risks with Shorting

As you may have already figured out from the previous description of how to conduct a short sale, there is one obvious risk. If you bet against a stock expecting the price to decrease and that doesn't happen then you will lose money on your investment. It's not as financially devastating as making a bad bet on an stock option contract on margin, but it can still be a significant loss if not monitored closely.

In our earlier example of the $10,000 purchase of ABC Co. stock, the price decreased to $7 per share. What happens however if the stock goes up to $15 per share on a surprise earnings announcement. You can no longer buy the shares on the open market for less than what you sold them for during the short. In order to cover your position you will need to purchase 1,000 shares at $15 per share which means a loss of $5,000 plus fees and commissions. For investors with an innate ability to properly evaluate stocks, conducting a short sale can be a great way to make money in bear markets or when initiating a contrarian investment strategy.

Image by: Thomas Hawk