Stock shorting is a common practice in the stock market that many investors are not aware of. Stock shorting involves borrowing shares from someone else, then selling them with the aim of buying them back at a lower price to pay off the debt. Stock shorting can be used for two purposes: making money on rising stock prices or hedging against falling stock prices. This blog post will cover how easy it is to understand this process and why you should consider using it as an investment strategy.
What is a short sale, and how does it work?
When you short sell a stock, you borrow shares from someone else and then sell them immediately. You hope that the stock price goes down in the future so that you can buy it back at a lower price and give the shares back to the person who lent them to you. This is different than buying stocks because when you buy stocks, your goal is to make money when the price of the stock goes up. With short selling, your goal is to make money when the stock price goes down, which is why it can also be used as a strategy for hedging.
The formula to calculate your short-selling profit:
Profit = (stock price when you short sell – stock price when you buy back the shares to pay for your debt) * (number of shares shorted)
How to get started with a short sale?
If you have a brokerage account, short selling is as easy as placing an order. You can place your order on the stock exchange or through your broker, depending on how they handle their orders. If you are using a full-service broker to make this trade, then there might be additional fees on the transaction that will reduce your gains. Stock prices change quickly, so it is important to know where and when to buy shares of the company in question before choosing whether or not you want to short sell them. The price difference between buying back these shares at the end of the day needs to cover all costs involved with doing business, which includes commission fees charged by both platforms (if applicable), interest rates if money is borrowed, and the bid-ask spread.
Pros and Cons of Short Selling Stocks
There are several pros of short-selling stocks. One is that you can make money when the stock price goes down. Additionally, if a company is doing poorly, short sellers can profit from its collapse.
Another pro of short selling is that it can help keep stock prices in check. If too many people start buying a stock and drive up the price, shorts can sell shares they borrowed to drive the price back down. This helps to ensure that stock prices are more accurate reflections of a company's worth.
Short selling is also a good way to make money in the case of panic. Often, shorting stocks with bad news can lead to quick profits with very little risk. You don't have to worry about being right or wrong with your stock predictions as much because there are many opportunities for you to profit even if a stock price falls by just a few cents.
While short selling can be a great way to make money when stock prices fall, it is important to understand the risks involved. Stock price declines do not always equate to profit, and many brokers require that you have enough cash in your account to short. This could result in an overdraft charge from your bank if they believe that there will be a negative balance at the end of the day. Shorting stocks can also lead to margin calls which means you need more funds put up front before being able to borrow any additional shares from another investor.
Stock prices can go up instead of down, which means you will be on the hook for buying back these shares at a higher rate than when they were initially sold. Stock shorting can also lead to "buy in" price where your broker forces you to buy back the stock at an inflated cost even if it's not selling anywhere near that higher price.
Stock shorting can also be confusing for novice traders who do not know what they are doing. Stock prices change quickly, and your broker needs to have enough cash in your account at all times before allowing you to sell shares of a company that you own.
Lastly, when you're long on a stock, your losses are limited to how much you paid for the shares. But when you're short on a stock, your losses are theoretically unlimited, which makes shorting a risky proposition.
Tips for Beginners who want to Learn More about the Stock Shorting process
Research the Company before you Short it
Stock prices change quickly, and it can be difficult to predict when a stock price will rise or fall, so it is important that you know what you're investing in before shorting. One way to short is based on new public information that affects a company's outlook. The other is by doing fundamental analysis where you can determine if a stock is overvalued and likely to go down.
If you are shorting a stock because of negative news, make sure the information is reputable and not just some rumor that could drive the stock price up instead of down.
Remember: your goal is to sell borrowed shares at a higher price than when you bought them back, so it's important to have realistic expectations about how much the stock will decline in price.
If you are shorting a stock because you believe it's overvalued, make sure that the company is actually doing poorly, and not just experiencing a short-term blip. It's also important to monitor the overall market conditions to see if any indicators suggest a stock price decline is imminent.
Understand what a Margin Call is and how to Avoid One
A margin call is when your broker asks you to deposit more cash into your account to continue borrowing shares. This can be a problem if the stock price starts going up instead of down and you don't have the extra funds to cover the cost.
One way to avoid a margin call is by having a cushion in your account that will at least cover the buying back of shares plus interest and fees. You should monitor your short positions regularly and sell them as soon as they reach your desired level of profit.
Now that you know more about short-selling stocks, you can decide if this investment strategy works for you. Just remember to do your research first and be aware of all the risks involved. Happy investing!
If you want to short stocks based on fundamentals, check out Wisesheets, where you can get historical financials, key metrics, and live data right on your Excel or Google Sheets spreadsheet.
The Wisesheets Team