A Basic Introduction to Shorting Stocks
Stock shorting is a trading strategy used by investors who believe that the value of a company's stock is going to fall, and they want to profit when it does. The act of stock shorting is selling shares of a stock that you do not own, in anticipation of the stock value dropping so you can buy them back at a later date…for less money than you sold them. In other words, you’re trying to buy low and sell high, but in reverse.
The question many people will ask at this point is, "How can you sell something you don't own?" Well, when you short a stock, your broker has to locate shares for you to borrow either from the firm, a customer of the firm, or another broker. Once you place the short sale order, you have to start paying margin interest on the amount you sold until you buy the shares back.
Over the course of the last couple of years, short sellers have made quite a bit of news, and have often been vilified. Those who aren’t familiar with the investment strategy, or don’t fully grasp the concept, are sometimes lead to believe that short sellers are responsible for the downfall of certain companies, or even the economy as a whole. This simply isn’t true. If you place a bet against a certain team in a sporting event and that team loses, you didn’t cause them to lose, you just profited by acting upon your belief that they would lose. Stock shorting is no different.
Stock shorting isn’t just gambling, it’s a legitimate part of a healthy free market system. For the stock market to function properly, you need to have both buyers and sellers. The price of a share of stock will find its value in the market based upon how many are buying and how many are selling. Those who buy think the stock is going higher, those who sell think it’s going lower, and theoretically, the two will move the stock until it reaches an equilibrium that is the true value of the shares.
Why Short Stocks?
There are two main reasons why an investor will engage in stock shorting. The first is speculation. It’s no different from buying a stock on the expectation of it going up, only you are shorting on the expectation of it going down, and thereby profiting from the trade. The second reason is hedging. Simply put, investors will short stocks to hedge positions from losses, or to lock in gains on a stock they don’t want to, or can’t sell at the time.
Those who are on the speculation side of the equation are taking large risks to do so. When you buy a stock, you have a finite loss you can incur. If the stock goes to zero, you lost the amount you invested. However, when you short, your losses are theoretically unlimited since there is no maximum to how high a stock can go. Additionally, since stock shorting is a margin transaction (i.e. you borrowed the shares you shorted) you will be paying margin interest on the trade for as long as you’re in it, and if the stock runs up in the market, you can get a margin call from your broker and be forced to buy the stock back at the higher price. These forced buy-ins can be avoided if you have liquid cash you can add to your account to meet the call, otherwise, you’re going to take a big loss.
Short selling isn’t for everybody, but there is a lot of money to be made shorting, if you know what you’re doing.