Selling Stocks You Don’t Own – An Introduction to Short Selling

You’ve probably heard the old expression that the only way to make money in the stock market is to buy low and sell high. While this is for the most part true there is often overlooked alternative using the very same words, just in a different order; sell high buy low. This is what short selling is, but how does it work and what are the dangerous that could be disastrous to your portfolio?

How Short Selling Works

Taking a short position in a stock is selling a position in a stock that you don’t currently own. This type of transaction is executed in the belief that the price of a stock is going to fall. So imagine that you believe the share price of Company Z will be going down in price from $10 to $6 and so you want to short the stock. You would contact your investment advisor or brokerage firm notifying them that you want to short the stock. The firm would then lend you the stocks and you would sell them directly into the market and receive the proceeds from the sale of the stock. There is however a minimum amount (margin) that your account must have in it in order to allow the transaction to occur.

Being the insightful investor that you are, the short trade paid off and the share price fell to $6, you now want to „cover your short.“ This is a Wall St. term for buying back the shares you initially sold. Since the price you bought the shares at ($6) is less than what you sold them at ($10) you get to keep the difference. You don’t keep to keep the shares however since they were just lent to you by the brokerage firm. The brokerage firm will charge interest on the loan of stocks, this is how they make their money on this transaction. You will profit when the short position is covered.

Margining Short Positions

The terms of margin used to determine how much money is the minimum you need to have in your account when you take on a short position in a stock. To cover the risk in this situation though the client must put up more than the total value of the short sale. The following is a list of the maximum loan values for short positions:

Stock Price… Maximum Loan Value

Reduced Margin Stock… 130% loan

$2.00 and above… 150% loan

$1.50 to $1.99… $3 per share

$0.25 to $1.49… 200% loan

$0.24 and below… 100% loan + $0.25 per share

The Risks Of Short Selling

Although there is a great opportunity to make money from downward markets by short selling, there is also considerable risks to be considered before beginning a short trade. Here are a few:

– Potential for unlimited losses. When you’re long a stock, the most you can lose is 100% (if the stock goes to $0). But when shorting a stock a price could go up infinitely, so you could stand an unlimited amount of money.

– Difficulty in finding enough of the stock to cover the short sale (therefore extending your losses, if it is going in the wrong direction).

– You are required to pay any dividends that are declared during the time you have shorted the stock.

– The price is subject to greater volatility when a lot of people are trying to cover their short positions at the same time (in Wall St. terms this is called a short squeeze).

With Great Leverage Comes Great Responsibility

Short selling is considered to be a leveraged position, much in the same way as buying a stock on leverage. Many of the same risks apply although short selling does have a few more risks it is also a great weapon to have in your investing arsenal. With short selling you are able to profit during the down turns and buy long in up markets. Profiting in both down and up markets should greatly increase your chances of profitability in the markets provided you know the risks and take the right safety measures to protect yourself.

Immobilienmakler Heidelberg

Makler Heidelberg

Source by Joseph Leo

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