In the bull market most of us make money, and in the bear market most of us lose money. Wouldn’t it be nice to change that, and make money in the bear market. With the advanced investing technique called short selling, it is possible.
However the concept of short selling doesnt come easy to everyone. In general, people think of investing as buying an asset, holding it while it appreciates in value, and then eventually selling to make a profit. Shorting is the exact opposite where you make money when the asset falls in value. The return rates can be high from short selling, but its comes with the added high risk.
The Basics of Short Selling
When you sell a stock (say X number), that you do not own, but are promised to be delivered in future, it is called Short Selling. So how can you sell a stock you do not own ? Basically your broker will lend it to you. Sooner or later you must buy back the same X number of stocks (covering) and return them back to your broker. When you buy back the stock at the lower price than you sold earlier, you obviously made a profit on the difference. However if the stock price rises, you end up losing money.
Most of the time, you can hold a short for as long as you want. However, you can be forced to cover if the lender wants back the stock you borrowed. This is known as being called away. It doesn’t happen often, but is possible if many investors are selling a particular security short. If there was any dividend distributed, you need to pay it to the lender of the stock. Also because you have loaned the stock, you are buying on margin, which means you will need to pay an interest.
Two main reasons why investors short are: speculating & hedging.
Restrictions on Short Selling
There are few restrictions imposed on stock selling so that investors can’t sell short in a declining market.
- You cannot short sell penny stocks (under $1 stock).
- Most short sales need to be done in round lots.
- There are rules (uptick rule) preventing the short selling to take place unless the last trade of the stock is at the same or higher price.
Short sellers use an endless number of metrics and ratios to find right stocks to short. Some use a similar stock picking methodology to the longs. Others look for insider trading, scandals, options backdating, changes in accounting policy, or bubbles waiting to pop. One indicator specific to shorts that is worth mentioning is short interest.
This reveals how many shares have already been sold short. It’s a dangerous sign if too much stock is sold short before you initiate a new short position.
Shorting is risky business. Let us look at few reasons for high risk.
- Over the long run, most stocks appreciate in price (inflation is one reason). This means that shorting is betting against the overall direction of the market.
- Downward movement of the stock is limited (max it can go to zero), whereas the upward movement does not have any limit. This means that you can lose alot more than you invested, but you can earn a max of 100% in returns.
- When trading on margin, if your account falls below the minimum maintenance requirement, you will be subject to a margin call and forced to either put more cash in your account or sell/cover your stocks.
- If a stock starts to rise and a large number of short sellers try to cover their positions at the same time, it can quickly drive up the price even further. This phenomenon is known as a short squeeze. A short squeeze is a great way to lose a lot of money extremely fast.
Love Them, Hate Them
One cannot deny the valuable contribution short sellers make to the market. Short selling provides liquidity in the market, drives overpriced stocks down and helps balance the overall market. Short sellers are often the first line of defense against financial fraud.
On the other hand, short sellers aren’t the most popular people on Wall Street. They are considered party poopers and are to be blamed for major market downturns. Some short sellers also use unethical tactics (short and distort) to make profits by taking short positions and then using a smear campaign to drive down the target stocks. Short selling abuse like this has grown with the advent of the Internet and the growing trend of small investors and online trading.
Conclusion: With the knowledge of short selling, you have added another trading technique to your toolbox. Short selling can be great way of making money in the bear market. You make money by short selling when the stock price falls. However short selling can be very risky and you should proceed with extreme caution. Short selling is not recommended for investors beginning their journey at the stock market.
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