Short Selling Stocks Is An Upside Down Way To Gain Profit
Buying low and selling high is the conventional objective for most stock investors
, and for good reason. It guarantees profits and delicious martinis to intrepid stock traders the world over. If only it were that simple, then the track records of even the most successful investors would be better than the ongoing struggle to beat the stock market averages over the long haul.
In an effort to perform better and beat the market averages, the experts occasionally go against the crowd. These specialists employ less conventional tactics like "short selling", which is essentially the mirror opposite of the normal practice of buying low and selling high.
In fact, it's buy high and sell low, or more correctly, sell the stock now at a higher price and buy it back later at a lower price.
This practice isn't common and is somewhat controversial as it presumes through rigorous analysis that a company is headed towards a downturn in some fashion. It may be an internal factor like an operational or competitive deficiency, or it may be external like a macro-economic or regulatory issue. Regardless, the resulting conclusion is that the stock is headed downward in price over some future period of time.
But the kicker with shorting is that stock prices usually rise like a balloon filled with helium - slow and steady, but fall like a brick - fast and hard. The downside is that stocks can only fall at most 100%, their entire worth. In contrast, a stock can double, triple, even go up ten times in price. A cool 1000%. The short seller could be wiped out in such a case when the stock must be covered, or "bought back" at the elevated price.
For example, in the above case, the short-sold profits gained from complete liquidation may be $1,000. But the short-sold loss from a ten-banger gain would be $10,000.
Techniques To Employ A Shorting Strategy
There are several ways to short a stock, and all include risk and require proper execution as with any legitimate investment approach.
One popular, and somewhat different route, is to use the leverage of options. Also known as a derivative, an option represents 100 shares of stock, of which you can "own" via an "option contract". An option position that presumes the share price will fall is called a Put. Buying a position that profits from a rise in price is known as a Call.
For this privilege, you pay a relatively small investment that represents the most you can lose on the transaction. If the trade goes your way, the return on investment can measure in the hundreds or even thousands of percent.
Of course it isn't that cut and dried. To achieve this degree of success, you must not only right about the direction and it's magnitude, but also right about the time frame. This one-two-three punch can be very difficult to achieve in reality thus the excess returns should you get it right.
The other most common method is sell the stock short. In this case, the broker will "borrow" the stock from another share holder or brokerage firm. The broker will then sell the stock and place that money into your account.
One important aspect of this approach is that you will be using a "margin account" where the broker can lend you money with the existing cash and securities acting as collateral. This is a requirement for short-selling stocks.
Once the money has been deposited, you now have a liability to buy back or "cover" these shares at some later point in time. The objective is to sell them back at a lower price than you paid so that you may pocket the difference. Should the price rise in the interim, you must cover the difference in addition to what you paid, resulting in a loss to you. Therefore, if the stock triples in price you're paying up another 200%. Even worse, you'll have paid an ongoing interest rate charge as part of having been loaned the stock.
In summary, short selling provides an investor with another tool they can use to approach volatile markets that are moving up and down is short order, profit off the poor outlooks of struggling companies, and leverage the truism that share prices often go down much farther and faster than they go up in the short term. Additionally, put options can be used to "hedge" losses against a big winner. Like buying insurance, you simply give up some gains for security and restful nights.
Short sellers sometimes get a bad rap due to the negativity of the approach, but they must be studious and astute like any investor, even more so due to the magnitude of potential losses. They're merely assuming the other side of a trade on which there will always be a winner and a loser.
by: Ryan Round
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