The Pros and Cons of Short Selling Stocks
Did you know that owning stocks was more common from 2001 to 2008 before the recession? Back then, 62% of Americans said they owned stock, but the number has not rebounded since 2008.
If you are interested in stock investments, it’s important to know about short selling stocks. Keep reading to learn the buzz about this topic.
What Is Short Selling Stock?
The short selling process begins with the short seller trading in borrowed stocks. Trading happens through brokers who offer the service.
A broker buys the stock, lends it to you, and you get to sell it. Once you sell the stock, your account through the broker will be credited with the sale proceeds.
The agreement is that you’ll buy the stock in the future to return the loan to the broker -this process is called covering the short.
The broker retains a fee and collects dividends from the investors shorting stocks.
As an investor, you will buy into stocks that you believe are declining in price based on market stability. Investors inherit all of the risks with this strategy. Most brokers will ask investors to cover the short.
Pros of Short Selling Stocks
Even though there are risks, there are pros to short selling. These are the main advantages to know:
Little Capital Needed
If you want to invest and make a significant profit with little capital, you can! The only thing required up front is a fee.
If prices continue to fall after you invest, you have the opportunity to earn a profit.
Earn Money in Falling Markets
Shorting the market is a strategy that fund managers and investors use to make money when market prices are falling.
If the market situation leads to the falling of stocks, utilizing shorts is the only way to earn a profit at the time.
Hedging a Portfolio
Shorts in your portfolio can hedge your portfolio once the stock is in there. Hedging against the stock falling prevents you from losing out on profits if the price of a stock drops. Your investment won’t be at risk.
For significant investments, hedging can help manage the volatility of the stock market.
Cons of Short Selling Stocks
Of course, any investment you make comes with some cons. These are the disadvantages to be aware of:
When you short a stock, you are taking an impractical approach. Markets have rises and falls and investors work off of the idea of investing on an assumption.
Focusing on just the price falling limits the potential for profit. Less potential is also high.
Because there is a limited range of profits, the risks are very high. If the share price of a stock rises, an investor has to deal with the increased price difference in addition to the broker’s fees.
The short sale stock process can cause a stock to dip significantly instead of seeing a regular market adjustment. The 2008 crisis is a prime example of how short-selling stocks led to bankruptcy.
Short selling stocks resulted in crashes for these companies:
- Bear Stearns
- Fannie Mae
- Freddie Mac
- Lehman Brothers
These crashes eventually led to the financial crisis of 2008.
Short Selling Profit Example
Short selling can be kind of confusing for newbies so we’ll provide you with an example that generates profit.
Picture a trader that believes “stock 123” will decline in price within the next three months and is currently trading for $50. A trader will borrow 100 shares and sell them to a different investor.
The trader is then “short” 100 shares since they sold stocks they don’t own but borrowed. Short sales are only made possible by borrowing shares. This option is not always available if the stock is heavily shorted by other traders.
Later on, the company that had its shares shorted reported low financial results that caused its stock to fall by $10. The new price is $40 per share.
The trader decides to close the short process and buy 100 shares for $40 to replace the shares they initially borrowed.
The trader will profit from the short sale since the stock price went down on the open market. The trader’s profit is $1,000 using this calculation:
- $50 – $40 = $10 x 100 shares = $1,000
This number does not include interest or commissions on the margin account.
Short Selling Loss Example
Using the same scenario from above, the trader doesn’t close the short sale at $40. Instead, they decided to leave it open in an attempt to further capitalize on a declining price.
A new company acquires the company and causes the stock to soar. The new share price is $65. If the trader closes the sale at the new price, they lose on the short sale.
This loss happens because the trader had to buy back the shares at a much higher price to pay back the shares they owe.
The long short equity strategy is common in the hedge fund industry but tends to have performance issues that traders cannot overlook.
Short Selling: Is It Right for You?
Short selling stocks is a risky strategy that can lead to high returns or large losses.
When you make a short sale, you are initially borrowing shares from a lender and hoping that the stock market sees a dip.
Because the stock market is highly volatile, only professional traders who complete a lot of research to utilize this strategy. If you are new to stock investments, consider going with the basics until you learn more.
For other informative articles like this, check out the other posts on our website.