|
Short selling - Or how to profit in a bear market |
||||||
|
Short selling explained
Short selling is the reverse of buying stocks, or the investment process. First, you sell and then you buy back. To do this you “borrow” stock from a brokerage firm to sell on the market. You do this because you are hoping to buy it back at a lower price and return the original borrowed stock to the brokerage firm and earn a profit. When you buy back the shorted stock, you cover the short position.
Short selling is one of the ways traders make money in a bear market. The following is a outline of how short selling works.
Step 1: Borrow shares of stock from your broker. There is a difference between buying shares and borrowing shares. When you buy shares they are yours to keep, as long as you want. When you borrow shares you must return them upon demand.
Step 2: Sell the shares you borrowed.
Step 3: Wait and hope for the price of the stocks you borrowed to drop.
Step 4: Buy back the same number of shares of stock you borrowed. If the stock price rises instead of drops, you will have to spend more money to get the stocks back. You only make a profit when you can buy them back cheaper than you sold them.
There are risks to consider if you sell short. Because the stock you sold was borrowed, it must eventually be returned to the lender. If the stock’s price has dropped, you make a profit because you are able to buy it back for less than what you borrowed it for. If the stock’s price increases, you will lose money because you will have to pay more than what you originally sold the stock for.
When you invest your money buying shares of stock, you can only lose what you paid for the stock. However, when you short stocks, the amount you can lose is limitless (theoretical) because a stock’s price can rise indefinitely (the sky is not the limit ..). A short seller should know that as the price of a stock rises, the current margin drops, thereby reducing the current equity. A margin call will be made if the maintenance requirement is not met.
A maintenance requirement is a rule that a stock holder’s equity must not fall below a certain percentage.
Below is an example of a short sell and short cover - Round trip example. We assume that you have $100’000 in your account.
There is more
Not only you have to pay interest when you lend a stock, but also you have to come up for dividends. Means, if a stock pays a dividend during the time you borrow it, you have to pay the dividend to the lender, out of your pocket.
Stocks may not be shorted at all times. There might be up tick rules involved. This means, you only can sell short a stock if the last tick, price movement, was up and not down. You might remember that you want to profit from a bear market, where average price movements are more down then up. However, the up tick rule may not apply to every market instruments.
Also keep in mind that the profit when selling short is limited. Since a stock only can fall to minimal value of $0. If you however buy stock, the profit of the investment is limitless.
In general, over time, stock markets have risen more then fallen. When you would have had bought stocks in early 1920 and still would be alive, you would certainly made a profit (in points, inflation not considered), despite all the crashes along the way.
Summary
Short stocks which
· have high liquidity · don't pay dividends · are widespread owned · when you have already some experience as a trader
(C) Copyright 2008, easyStockDater, Inc. |
|
Did you know ?
The stocks that are borrowed for a short sell transaction come primarily from margin accounts.
Margin accounts allow you to borrow against stocks and other securities deposited into the account.
When you open a margin account you usually sign a margin agreement, which may incorporate a stock loan consent form.
The stock loan consent from allows the brokerage house to lend. |