Learning how to short a stock is a must for investors playing the most expensive game of risk. Nobody likes to lose – and making a bad decision in the stock market can make or break your business.
Choosing stocks to invest in is a huge responsibility. Therefore, it is best to figure out everything you can about the industry before proceeding with any big moves.
Traditional Short Sale
One way to invest is through shorting a sale. From the term itself, a short sale means you will only have a momentary possession. Compared to a long sale which is more like owning a stock.
Through the short sale process, you borrow shares from a stock that an investor already owns. You are obliged to return it to the stock owner after a certain time frame. From here, you sell the stock that you borrowed and keep the proceeds.
Eventually, you will have to close your short and buy back the shares from the investors. If the value of the shares decreases within this time frame, then it’s very good news for you.
You can buy back the shares for less than the amount you borrowed from the original stock owner. This means you also get to keep the leftovers from the decreased price when you return the shares.
However, things could go very badly if the value of the shares increases. You’d not only have to pay the same amount as what you borrowed, but you would have to compensate the increase.
If this happens, you don’t just lack profit, but you will lose from your savings as well.
Monitoring Stock Market Trends
Like everything else, the short sale process is dependent on stock market trends.
Think of it this way: If you borrow stock at $100 per share – and after some time, the stock value decreases to $40 per share – the remaining $60 per share is yours.
However, if the stock rises to $150 per share, then you’ll have to pay the extra $50 per share just to buy back the stock and return it to the original stock owner.
Aside from the daily reports seen in the news, technology has now provided a plethora of tools for monitoring the stock market. Some of these tools analyze the stock market as well, such as the stock market simulator.
Shorting A Stock With Options
You can also short a stock using an options strategy. Buying a put option and selling a call option at the same strike price and expiration date creates a “synthetic” short position. If the stock drops, then the value of the put option will increase. If the stock trend rises, then the value of the put will decrease, and the value will increase.
An options strategy has features that you wouldn’t get with a traditional short stock. The primary difference is that the options strategy places a time limit on the short position.
When the options expire, you either have to close out the position or comply with the options contracts. With a regular short sale, the lack of a time limit gives you more flexibility to profit long-term from a share.
However, the traditional method is a bit more spontaneous. Whether this degree of order is a pro or a con depends on how you handle your investments.
Short Stocking As A Backup Plan
Shorting a stock is generally viewed as riskier than just owning stock because of the potentially unlimited losses that could come when you short a stock.
Owning a stock means you can’t lose more than what you invest while shorting a stock can make you lose a hundred times more than your investment in a snap.
That said, short selling is still a good move to have up an investor’s sleeve – but only if used correctly. The stock market is predictably unpredictable, and both traditional and option-based short positions can give you immense opportunities for profit.
If you trust in your foresight, knowing how to short sell a stock can keep a company afloat through a rough business patch. If you just invest in owning stocks, your profit will dwindle with the stock market environment.
However, with short stocking, your odds could be different. It’s good to still have the means to earn from the stock market even if your shares drop.
Pros & Cons Of Short Stocking
The difference between a short sale and a long sale (full ownership of stock) is pretty self-explanatory.
Compared to owning stocks, short stocking is like testing the waters – it is not an all-out investment. However, in this case, the waters are full of hungry predators and you’re bleeding.
As such, it is debatable which one is more applicable to the stock market today. Short stocking may not be a long-term decision, but it could reap you a lifetime of effects.
The biggest perk of shorting a stock is that you can profit from a decrease in the value of an investment. If this were the case of fully owning a stock, the opposite will happen and you will lose profit. Although it’s a gamble at best, short selling provides a more versatile way around stock market trends and values.
However, you should always consider the market environment before investing in this method. For example, this method would work great for bull markets with a lot of stocks going up, but what if the market crashes? How will you gain from it with this method?
Aside from gaining through falling stocks values, shorting stocks has the following advantages:
• Having a versatile market game plan that includes both owning stocks and selling stocks short.
• You can buy the stocks with the best prospects and short stocks with the worst ones, creating a considerably more stable profit regardless of whether the market will rise, fall, or plateau.
From those explanations, you’d think short selling is an investor’s dream – but the downside is also pretty extreme: there is no theoretical limit to how much losses you might suffer.
For a long sale, an investor’s nightmare is for their owned stock to become worthless, making them lose their entire investment. For a short stock, values can increase dramatically and could practically put you in debt. You could end up paying a hundredfold of what you initially invested.
- Short selling is constrained by special regulations not found in regular stocks.
• In some scenarios, certain exchanges may limit short selling activity during peak market volatility without putting those restrictions for regular long positions in the same stock.
• You don’t have as much time between buying/selling a share and closing it out. The original stock owner can ask for their shares back anytime, which won’t give you enough time to wait out when the value of the share will decrease. It could also potentially catch you at a time where the value of the share has increased, making you lose profit and more.
How Do I Short A Stock?
If you’re wondering how to short sell a stock, here’s how the process goes:
First off, you must have a margin account and pay interest on the value of the borrowed shares while the position is open. The New York Stock Exchange (NYSE) has set minimum values for the maintenance margin, or the amount that should constantly remain in the account.
Once your account value falls below the maintenance margin, you will have to pay more interest, or the position would be sold.
To close the short position, you’ll buy the shares back at a price less than what you borrowed for the asset (ideally), returning them to the lender or broker. Investors must compensate for any interest or commissions charged.
The process of identifying shares that can be borrowed and returning them at the end of the trade is handled by the broker (or by yourself, online).
Opening and closing the trade is done with regular trading platforms for most brokers. However, brokers require certain qualifications that the trading account should meet before they give the go-signal for margin trades.
The risk-reward ratio for buying and selling stocks is a bit more extreme when it comes to short stocking. Throughout each advancement in the process, you are one step closer to gaining huge amounts or losing everything and more.
It is best to think of short stocking as a huge-scale loan. Typically, you shouldn’t bite off more than you can chew.
There’s no shame in being safe. If you don’t feel as confident in your foresight, then it’s best to err on the side of caution. However, they say that nothing good ever comes without a little risk.
If you think you will gain the most rewards or your investments will prosper through this method, then why not? You just have to make sure you have collaterals and Plans A through Z ready should something unexpected happen.