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Selling Short with Stock Trading
from: Maxx Trading GuidesInvestors that implement selling short are taking the gamble that they will be able to buy the stock at a lower price than the price in which they sold short. Basically, the investor is selling stock that they don't own in order to make a profit. In other words, the investor sells stock that is promised to be delivered.
This concept may sound thoroughly confusing, but actually, selling short is an advanced stock market order that, once explained, is easy to understand.
When you sell short any given stock, your stockbroker lends it to you. The stock usually comes from either a personal investment of your broker from another customer in which your stockbroker works with. The shares are sold and the profits are given to you, the investor. If this seems too good to be true, you are right! Later on, you must buy back the same number of shares and return them to your broker, with an interest rate added to the cost of each stock.
Basically, you're taking out a loan in which to purchase stocks, and then, whether you've made profit or not, you must repay the stocks to the broker. Pending that the price per stock drops, you are able to buy back the stocks at a lower price, which means that you have gained money, however, if the price per stock increases, you must still buy back the stocks, and thus, you lose money. In general, you can hold a short for as long as you want, meaning that you can wait until you have made enough money to buy back the stocks before doing so.
However, there are times when the stockbroker wants his stocks returned and at that point, you are forced to purchase the stock. Obviously, stockbrokers are unable to sell stocks that they do not have, therefore, if they have over compensated and sold all of their stocks, it is quite possible that your broker will begin to pressure you to buy back the stocks.
Obviously, when you begin to "play" with your brokers stocks, there are risks involved. Below are 4 distinct risks when selling short.
In general, stocks tend to appreciate in price, therefore, when it comes time for you to buy back the stocks in order to repay your stockbroker, you lose money due to the fact that the price per stock has gone up. For example, you borrowed stocks from your stockbroker that are sold at $350 each. When you buy back the stock to repay your stockbroker, you notice that each stock is now being sold for $500, therefore, you are losing money.
You can lose more money than you initially invested. Because selling short involves using borrowed money, it is extremely easy for losses to get out of hand. This type of order is similar to a credit card. Most people, when using a credit card, overspend; the same is true with selling short because it is not your money that you are working with. Initially, when you borrow the money, you are sure that you are able to make the total amount of borrowed money, plus a profit, so you oversell the stocks. Then, when it comes time to repay the stockbroker, you have lost money, and could quite possibly not have the funds for repayment.
If a stock starts to rise and a larger number of short sellers try to sell their stock, it can force the price of each stock to rise. Therefore, it is more expensive to purchase each stock, thus, you lose money.
Taking these risks into consideration when selling short can help to reduce the total amount of money that you lose.
Pending that, short selling fits into your risk tolerance, it is an easy and quick way in which to make money when you don't have any. However, it takes extreme knowledge to be able to effectively execute a short sell. It'is better to leave a short sell up to professional investors who have numerous years of experience in the stock market.
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