Definition of shorting a stock
Table of Contents
What does it mean to Short A Stock?
It’s almost impossible to be part of the stock market without coming across the term shorting a stock. But, suppose you are new around the block and unsure what it means, not to worry. We have got you covered.
If you are shorting a stock, it means you are executing a bearish position with borrowed shares and selling to another investor — More like selling a stock you don’t own (borrowed). As you may already know, day traders only short an asset when they feel strongly that the price will head south or decline.
Short-selling stocks provide traders with an Avenue or opportunity to profit when stocks go down in value. To do that, you will have to borrow the stock from your brokerage company and sell with the hope of buying back the stocks at a lower price. Whatever money remains after buying back the stock becomes profit for the short-seller.
How about we take a look at an example to help you understand better?
From your analysis of the market, you may conclude that a particular stock is overpriced, say at 100 dollars per share and decide to go short. To short the stocks, you will have to borrow ten shares from your broker and sell for 1000 dollars.
Hopefully, the price sinks further from the original price and hits 90 dollars. At this point, you can come back and buy the same stocks for 900 dollars and return them to your broker while you keep the remainder of 100 dollars as profit.
As a risk-driven investment, a short-selling stock has two sides to it — it can either fetch you money or take from you. But, contrary to popular misconceptions, shorting a stock is no walk-in-the-park and is quite different from owning stocks.
When does shorting a stock make sense?
Have you ever wondered why only a few investors get involved in short-selling stocks? The answer is not far-fetched.
The general market behavior primarily drives the reason why few investors participate in shorting a stock. Instead, when people buy stocks, they intend to hold them and see them rise in value.
As with virtually every financial market, including the stocks market, dramatic fluctuations occur over a short period, but the back eventually returns to its original trajectory or bias.
Considering the frequency and extent of fluctuations in the stock market, few trades or investors are keen to dabble into short-selling stocks. However, it’s always best to consider it as a short-term strategy if you must short stocks.
In the course of your trading, you may stumble upon an investment and you are convinced the setup fulfills every criterion for short. In such a situation, short-selling the stock is the quickest way to profit from the company’s misfortune. That way, you get to rake in decent profits while others watch their portfolio pop in red.
What are the risks of short-selling a stock?
As we mentioned earlier, shorting a stock can swing both ways. If you get the right call at the right time, you will be smiling to the bank. However, it exposes you to more risks compared to what regular stock investors are exposed to.
Not to beat around the bush, the risk of shorting a stock outweighs the potential profits as opposed to buying stocks (which presents unlimited profit potential and less risk).
Think about it. When you buy stocks, there is a limit to how much you can lose if the market goes against you. You only lose what you paid for it and nothing more if it dips to zero.
On the other hand, if the market swings in your favor and everything goes as planned, there is no limit to the profit you will enjoy. And this is what is obtainable when you opt for long-term stock investment.
When you short-sell a stock, the dynamic is reversed. You are now looking at limited potential profits and staring down a barrel of “unlimited” loss. For instance, suppose you short-sell100 shares at 10 dollars per share, and the stock drops to zero, you get to keep a whopping $1000.
On the flip side, if it rockets to $100 per share, you would have incurred a net loss of $9,000 because you will have to spend $10,000 to buy back the same number of shares. Mind you, this magnitude of loss is not impossible in the financial markets as several accounts have taken such a hit.
Is there an alternative to shorting a stock?
The most accessible alternative to shorting a stock that can limit your exposure and prevent you from sinking further is to buy a put option. Buying a “put option” in stock lingua, means purchasing the right to sell a stock at a predetermined price. Again, underscore the word “right.” Put options give you the right and not an obligation.
For instance, if you buy a put option in stock at a predetermined price, also known as the strike price of say 100 dollars, and the stock drops to $60. Executing a put option allows you to buy the shares at $60 and sell them when the price climbs back to $100. As such, allowing you to benefit from the decline.
We are rounding off
Rounding off on this topic, here are some frequently asked questions about shorting a stock and our responses. Hopefully, it gives you more insight on the subject.
When should I close my position?
This depends entirely on your trade plan. If the stock reaches your stop loss, you would then click “cover” or “buy.” This will allow you to close out the position and protect yourself from further losses.
With a trading plan, you would also have profit targets. And once the stock begins to reach those levels, you would start to lock in some profits. And like before, this will be done by clicking “cover” or “buy” this will allow you to close your positions.
What type of account do I need to short stock
You would need to have a margin account to short stocks. This is because you are borrowing the shares at the moment you open a short position. And since it’s technically a loan, you can only accomplish that in a margin account.
Is there any other way to short without a margin account?
The only other way to participate in a downward move via shorting a stock is using options contracts. You can buy these contracts in a cash or margin account. The option contract you would buy to short a stock is called a “put” contract. To short via “put options,” you will need to buy the option (not sell or short). As the stock goes down, the “put option” will grow in value.
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