Do you keep hearing about rising stock markets in the news and don’t understand half of the words? Do your friends buy and sell shares and stocks and you feel that you are left behind? This short post is a quick guide about short selling, and will give you some definitions and terms you need to know before you can start short selling.
Learning The Stock Market
Do you keep hearing about rising stock markets in the news and don’t understand half of the words? Do your friends buy and sell shares and stocks and you feel that you are left behind? This short post is a quick guide about short selling and will give you some definitions and terms you need to know before you can start short selling.
A buy or sell order usually involves the purchase of a given stock at a certain price in the hope that the investor can make a profit by selling the stock later, and at a higher price. The “opposite” transaction can also be carried out: The investor can sell a stock at a certain price and buy it again at a later date. Such an investor hopes that the stock price will fall, enabling him to purchase the stock for less than the price at which he sold it.
How Short Selling Works
An investor who sells a stock short is selling a stock that he does not actually own. In order to make this sale, the investor must first borrow the stock from a broker (in return for a certain fee paid to the broker). Borrowing the stock assures that the investor is selling stocks that actually exist in the market, and that can be delivered to the purchaser when the transaction takes place.
After borrowing the stock, the seller sells it on the market through an ordinary sell order. When the investor wishes to purchase the stock, he does so through an ordinary sell order and then returns the stock to the broker.
Short selling is restricted by what is known as the “Up Tick” rule. When a stock price goes down, the process of short selling in and of itself can accelerate its own fall. After the 1929 crash of the NYSE, it was regulated that a short sale cannot be carried out unless the price of the transaction preceding it is higher than was the case during the prior transaction. This rule prevents an artificial drop in the stock price caused solely by the short sale.
First scenario: The stock price is $7.50. The investor’s profit is $2.50 multiplied by the number of shares, minus the broker’s commission.
Second scenario: The stock price is $12.50. In this case, the investor loses $2.50, which is multiplied by the number of shares, plus the broker’s commission.
The Risks in Short Selling
1. Price Risk: When a person buys a stock, he can lose only the amount that he paid for it because no stock price can fall below zero. However, a stock price can rise by more than 100%, which means that a short seller is exposed to a theoretically unlimited loss. In order to cover the possibility that an investor might be wrong, and that the stock price may go up instead of down, he must deposit a guarantee with his broker to assure that the investor will be able to cover his short position if that should prove necessary.
2. Security Risk: The amount of the guarantee that an investor must deposit with the broker is based on the value of the borrowed stocks. If the stock price goes up, the broker may demand that the investor deposit additional guarantees to ensure that he will be able to cover the short position.
3. Cover Short: The broker can require the investor to cover his short position at any time. The timing of such a demand can be crucial to the investor, because it may force him to buy the stock at a higher price than the sale price thereby resulting in a loss on the transaction.
4. Short Risk: It is possible for many investors to take a short position on a certain stock. When the price of such stocks rise, and the investors who sold the stock short discover that they were wrong in thinking that the price would fall, they will try to cover their short position by repurchasing the stock, and sometimes at any price that is offered. This can aggravate the situation by forcing the stock price higher, which increases investors’ losses from short selling. This situation is called a “short squeeze”.
Find out more about short selling, stocks, bonds, warrants, mutual funds, options and much more in our online stock market course Fundamentals of the Stock Market.
You may also be interested to learn how to trade stocks for beginners by learning the stock market. That in itself would give you the basic ins and outs that you will need to master this exciting market and will also allow you to invest your own capital for a residual second income unless you are interested in building your own portfolio which can easily become your main income.
If you are seriously considering taking up investing in the stock market than you should start by reading this great post on How To Buy Stocks For Beginners which will give you the basics you need to start with.
Warning: Short selling is considered a risky investment, which is primarily undertaken by certified investors. An investor should, therefore, consult his broker before making such an investment.