Shorting stock, also known as “short selling” generally tends to fall into the domain of experienced investors and hedge fund managers. Its potential for huge returns is matched by its potential for huge losses. Shorting stock entails the selling of stock that the seller has no actual ownership over and has instead taken a loan from the broker in order to do so. This type of investing is incredibly risky and those partaking must be prepared for the fact that their gamble might not pay off.
Why opt to sell short?
Typically, you would opt to short stock if you were convinced that a stock’s price was on a downward trajectory. The strategy is that you’d sell the stock today and then buy it back at a lower price shortly afterwards. If the strategy works, your profits are the result of the difference between when you bought and when you sold. In the aftermath you end up with the same amount of stock you originally had. Some traders elect the short selling route only for speculation while others do it to hedge, or to protect their position.
A brief explanation
When you partake in short stock, you’re trading shares over which you have no ownership. For instance, if you assessed the value of a certain stock to be overpriced, you could borrow 10 shares of the stock from your broker with the intention to sell each stock for $50, netting you $500 in cash. The thing is, while you might have $500 in cash, you also need to purchase and return 10 shares to your broker as soon as possible. If the share price declines as you predicted to $25, you can then buy the 10 shares for $250. Thus, when all is said and done, in other words, after you’ve returned the $500 to your broker, you’ve made a profit of $250. That’s the upside of short selling. The down side is that if things went in the opposite direction, you’d end up buying back the shares for even more than you paid and you’d end up experiencing what could be a massive net loss.
What are the potential risks?
If you decide to short a stock, you’re exposing yourself to incredible financial risk. The volatility that comes with this type of investing cannot be understated. Never sell assuming that you’ll be able to repurchase the stock on your terms and at a price suited to your liking. Due the volatility of shorting stock, you need to be aware of the fact that a share price could rise and fall without following what could be deemed as a conventional path. You can also lose out if no one is selling stock or if there are too many buyers. Like most things in this business, it’s a fine line to walk and often one in which balance needs to be applied.
What are the alternatives
The risks inherent in short selling can be monumental, but there are other ways to invest, profit and run less risks, although risks will never be completely eliminated from this type of business. For instance, if you were interested in investments on FTSE and SP 500 indexes or on companies that make up for those indexes, you could elect to try your hand at spread betting instead. Like short selling, there’s no ownership over the stock. Instead you’re placing a speculative bet on the price movement of an asset, stock or an index. This means you’re not buying the stock, but instead you’re betting on its movement. The capital for this type of trading is much less, the profits can be good, but as always, there will be risks.