Most investors purchase a stock with the expectation that the stock price will rise. If all goes according to plan, the investor would eventually sell the stock and realize a profit. But have you ever felt certain that a stock price would fall? What if there was a way you could profit from that situation? There is! It’s called short selling.
Short selling is rather simple, but many investors struggle to understand the mechanics of the process. This technique also has some different risks to consider.
What is Short Selling?
In simple terms, short selling is the selling of a stock that is owned by someone else. Even though someone else owns it, you’ve made a promise to deliver it. When you short sell a stock, the broker lends the stock to you.
The shares are sold, and the money is credited to your account. Then, you finish the transaction by purchasing the same number of shares to replace those you were ‘given’ by the broker.
If the price has dropped, you can buy the shares back for less than the original price and you make money. However, if the stock goes up, you’ll lose money.
The following steps show the mechanics for making a short sale:
1. Set up a margin account with your broker. Any broker will offer margin accounts. This type of account allows you to borrow money from the brokerage company. Your investments are used as collateral.
2. Place your order. You can either call your broker or complete the sale online. There will be a box on the website marked, “Short Sale.”
3. The broker will borrow the shares. The shares may be owned by the brokerage firm, another brokerage firm, or another investor.
4. The broker then sells those shares and puts the proceeds in your margin account. If the price falls, you can buy back the shares you sold at a lower price and keep the difference. If the price rises, you’ll be forced to cover the difference.
The Risks of Short Selling
Short selling is risky. Over time, stocks have a general upward drift. Look at the value of the stock market now compared to 50 years ago.
The downside is greater than the upside. Remember that the lower the price falls, the more money you’ll make and that the price can’t fall below zero. But, in theory, there’s no limit to how high the price can rise.
You’re also borrowing money. If the stock price rises too much, you’ll have to put more money toward the investment. If you can’t pay more, your brokerage firm will be more than happy to sell some of your other investments to cover it.
You can be totally on track, but have poor timing. The stock might be overpriced, but it can take some time for the stock price to adjust. During this waiting period, you’re potentially on the hook for interest and margin calls.
Short selling is another investing technique for your toolbox. There is more risk involved with short selling, but there can be a considerable upside. You won’t need to invest much money to control a lot of stock, since you’re leveraging your other investments.
While short selling isn’t for everyone, it provides a big opportunity for those with the risk tolerance. Consider short selling when you’re very confident that a stock value will decline.