Short Selling: What to Know About Shorting Stocks The Motley Fool

For example, some news might get released overnight and cause the stock to go up a lot before the market opens. And most investors would do better sticking to a long-only portfolio. At Bankrate we strive to help you make smarter financial decisions. While we adhere to strict
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this post may contain references to products from our partners. Mercedes Barba is a seasoned editorial leader and video producer, with an Emmy nomination to her credit. Presently, she is the senior investing editor at Bankrate, leading the team’s coverage of all things investments and retirement.

  1. On the other hand, suppose Conundrum does not decline as you had expected but instead surges to $70.
  2. Given the challenges, even many of the professionals find shorting to be a grueling effort.
  3. Yet, short selling can limit the rise of stocks, and prevent them from running into a speculative frenzy, helping the market maintain order.
  4. In 2010, the SEC adopted an “alternative uptick rule” that restricts short selling when a stock has dropped at least 10% in one day.
  5. Short selling requires a lot of work and knowledge to succeed, and it’s not really a good idea for individual investors, who must match their wits against some of the sharpest investing minds.

In short, GameStop had caught the fancy of retail traders who had clubbed together on Reddit and other platforms to drive the stock up. Usually, you would short the stock because you believe a stock’s price will fall. In essence, if you sell the stock today, you’ll be able to repurchase it at a lower price later. Many traders prefer to bet against stocks using options contracts called put options. These trading methods have a max loss of 100%, unlike short selling, where the max loss is theoretically infinite. Short selling is incredibly risky, which is why it isn’t recommended for most investors.

To close the position, the investor needs to purchase 1,000 shares at $20 each, or $20,000. The investor captures the difference between the amount he receives from the short sale and the amount he paid to close the position, or $5,000. While short sales can be profitable under the right circumstances, they should be approached carefully by experienced investors who have done their homework on the company they are shorting. Both fundamental and technical analysis can be useful tools in determining when it is appropriate to sell short.

You must have enough cash in your stock trading account to cover the required margin – margin requirements vary among brokers. Essentially, a put option gives you the right — but not the obligation — to sell a stock at a predetermined price (known as the strike price) at any time before the option contract expires. At first glance, you might think that short-selling would be just as common as owning stock. Short-selling activity is a legitimate source of information about market sentiment and demand for a stock. Without this information, investors may be caught off-guard by negative fundamental trends or surprising news. A stock’s fundamentals can deteriorate for several reasons—slowing revenue or profit growth, increasing challenges to the business, and rising input costs that pressure margins, for example.

Investing involves risk including the potential loss of principal. If you fail to meet the margin call, your brokerage firm may close out open positions to bring your account back to the minimum requirement. Certain stocks may be designated as “hard to borrow” due to a lack of supply, regulatory restrictions, or the unwillingness of brokerage firms to lend out the securities. Short selling acts as a reality check that can eventually limit the rise of stocks being bid up to ridiculous levels during times of excessive exuberance. Short-selling can be profitable when you make the right call, but it carries greater risks than what ordinary stock investors experience.

Hedgers use the strategy to protect gains or mitigate losses in a security or portfolio, using it as a form of insurance. The most-publicized contemporary example of a short squeeze occurred when followers of WallStreetBets, a popular Reddit page, came together in January 2021. They wanted to generate a massive short squeeze in the stocks of struggling companies with very high short interest, such as the video game retailer GameStop Corp. (GME). The purchases of the stock by those following the Reddit page soon caused the company’s share price to soar 17-fold in January alone, squeezing major hedge funds that shorted the stock. Suppose you think that Meta Platforms Inc. (META), formerly Facebook, is overvalued at $200 per share and that its price is due to go down.

Short Selling: The Risks and Rewards

To protect the portfolio, the investor short sells shares of Meta as a hedge. If its price drops, the loss in the investor’s long position will be offset by gains in the short position, thus reducing the overall loss in their portfolio. When the market stabilizes, the investor can close the short position by buying back the shares while maintaining their long-term position in Meta.

For long-term investors, owning stocks has been a much better bet than short-selling the entire stock market. Shorting, if used at all, is best suited as a short-term profit strategy. In a traditional stock purchase, the most you can lose is the amount you paid for the shares, but the upside potential is theoretically limitless. Short selling a stock is when a trader borrows shares from a broker and immediately sells them with the expectation that the share price will fall shortly after. If it does, the trader can buy the shares back at the lower price, return them to the broker, and keep the difference, minus any loan interest, as profit.

Short selling has several major risks

Depending on the scale and nature of the short, it has the potential to magnify losses. Critics contend that it exacerbates downward price movements, heightens volatility, and causes an exodus of investors from the security being shorted. To short a stock, the trader borrows shares of the company from a broker-dealer and sells them in the open market.

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When stock or market fundamentals are deteriorating

If the shares rally to $100 each, you’d have to buy them back for $1,000 for a loss of $900. This, in theory, can go on indefinitely, and the longer you wait for the stock price to fall again, the longer you’re paying interest on those borrowed shares. Let’s say you own shares in a company and have doubts about its near-term performance, but don’t want to sell your shares. In this instance, you could continue holding your shares for the long-term while you short the stock, buying back in at a lower price if and when the stock’s value falls. That sounds simple enough, but there’s a lot more to short selling stocks than just understanding the concept, and the strategy comes with the risk of serious losses.

China tightens stock market rules after sell-off

Lower Saxony and Porsche, who together owned more than 90 percent of the company, would not be willing to sell their positions. Joe shorts the stock, betting that the company’s shares will decline to $50. He borrows 100 shares of ABC from a broker-dealer and sells them in the open market for $10,000.

This would represent a possible change in the behavior of the price action and the short seller might want to move on quickly. Shorting a stock enables traders to try and capitalize on declining markets. This video walks you through an example to demonstrate the basics behind short selling and how to mitigate the potential risks. If your hunch is wrong and the price rises, you are out the difference. If the price skyrockets, you have to buy it at whatever elevated price to return the stock to your lender.

Costs and risks of short selling stocks

So traders who believe that “the trend is your friend” have a better chance of making profitable short-sale trades during an entrenched bear market than they would during a strong bull phase. Short sellers revel in environments where the market decline is swift, broad, and deep, like the global bear market of 2008–2009, because they stand to make windfall profits during such times. Securities and Exchange Commission (SEC) under the Securities Exchange Act of 1934. Regulation SHO, implemented in 2005 to update previous rules, is the primary rule governing short selling.

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