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The Basics of Shorting Stock

Sebencapital

Published
04/01/24
The Basics of Shorting Stock

Shorting stock is a strategy used by experienced investors, like hedge fund managers, to make profits in trading. However, it's a risky method that can also lead to significant losses.

Short selling, another term for shorting stock, happens when someone sells stocks they don't own or borrowed from a broker. This strategy involves taking a gamble on the stock's value decreasing, and those who short stock should be ready for the risk that it might not go as planned.

Key Takeaways

  • People short stocks when they think the stock price will drop.
  • Shorting stock means selling stocks to earn money, then repurchasing them at a lower price.
  • Stock prices can change a lot, and it's not guaranteed that you can buy shares back at a lower price whenever you wish.
  • Shorting a stock follows different rules compared to regular stock investing.

Why Sell Short?

Typically, shorting a stock involves predicting the stock's price will drop. The aim is to sell it now at a high price and buy it back later at a lower price.

If this tactic succeeds, you profit by the difference between the selling and buying prices. Ultimately, you'll retain the same quantity of the stock you initially had.

Some traders short sell for speculation, while others use it to safeguard against potential losses from a long position.

Note

A long position often means owning shares of the same stock directly or a related stock.

How Shorting Stock Works

When you short stock, you're trading shares you don't own. Let's say you borrow 10 shares of ABC stock from your broker at $50 each, and then sell them to get $500 in cash.

If the stock price drops to $25 per share, you can buy back the 10 shares for $250 total. That means you make a $250 profit: the $500 you earned initially minus the $250 to buy back the shares. But if the stock price rises above $50, you'll lose money. For instance, if it reaches $250 per share, you'd need $2,500 to buy back the 10 shares, resulting in a $2,000 loss after keeping the initial $500.

Note

When you short stock, you're trading shares you don't own. Let's say you borrow 10 shares of ABC stock from your broker at $50 each, and then sell them to get $500 in cash.

If the stock price drops to $25 per share, you can buy back the 10 shares for $250 total. That means you make a $250 profit: the $500 you earned initially minus the $250 to buy back the shares. But if the stock price rises above $50, you'll lose money. For instance, if it reaches $250 per share, you'd need $2,500 to buy back the 10 shares, resulting in a $2,000 loss after keeping the initial $500.

What Are the Risks of Short Selling?

Shorting stocks carries a big financial risk.

In the past, there was an event called the Northern Pacific Corner of 1901. During this time, the Northern Pacific Railroad's shares soared to $1,000, leading some of America's richest individuals to face bankruptcy as they tried to buy back and return borrowed shares.
Huffard, R. Scott Jr. "Harriman vs. Hill: Wall Street’s Great Railroad War by Larry Haeg (Review)," Enterprise & Society, Cambridge University Press, vol. 16, no. 2, 2015, pp. 484-486.

Remember, when you short a stock, it's not always guaranteed that you'll be able to buy it back at your desired price whenever you want. Stock prices can change a lot.

When you invest, don't assume that a stock must go through a specific price to reach another. The market needs to exist for that stock. You might end up losing a lot of money if:

  • There are no sellers for the stock.
  • There are too many people trying to buy the stock because other short sellers are also trying to close their positions.

How Is Short Selling Different From Regular Investing?

Shorting a stock comes with its own rules, which differ from regular stock investing. One rule is meant to prevent short selling from excessively driving down the price of a stock that has dropped more than 10% in a single day compared to the previous day's closing price.
According to the U.S. Securities and Exchange Commission, the risk of losses on a short sale is theoretically limitless. This means that a stock price could keep rising without any boundary. It's a strategy best suited for experienced traders who are aware of and understand these risks.

Frequently Asked Questions (FAQs)

How long can I short a stock?

In theory, you have the ability to short a stock for an extended time. However, in practice, shorting a stock involves borrowing stocks from your broker, which often comes with fees. These fees continue until you repay what you've borrowed. Therefore, you can short a stock for as long as you can manage and cover the borrowing costs.

What is the opposite of shorting a stock?

The opposite of shorting a stock is called "going long." This term is used when traders start a position by making a buy order, unlike shorting where they use a sell order. Essentially, going long means purchasing the stock instead of selling it.

Does shorting a stock bring the price down?

One person's single short sale order usually doesn't influence the stock price much. Yet, when many people sell stocks, whether they're short sellers or long-term investors selling after years, it can push the stock price down. The collective effect of numerous sales can impact the stock price, regardless of whether it involves short selling or not.

How do you profit from a falling company without shorting the stock?

There are ways to profit from a stock going down without actually shorting it. One way is through options - buying a "put option" lets you sell a stock at a set price. If the stock falls below that price, you can sell it for more, making a profit. Another method is using inverse ETFs (Exchange-Traded Funds). These funds move opposite to the stock they're tracking. For instance, SQQQ moves in the opposite direction of QQQ. So, if you think QQQ will drop, buying a put option on QQQ or investing in SQQQ can both help you make money from that downward movement.

Written by Sauravsingh

Techpreneur and adept trader, Sauravsingh Tomar seamlessly blends the worlds of technology and finance. With rich experience in Forex and Stock markets, he's not only a trading maven but also a pioneer in innovative digital solutions. Beyond charts and code, Sauravsingh is a passionate mentor, guiding many towards financial and technological success. In his downtime, he's often found exploring new places or immersed in a compelling read.

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