If you think a stock is on its way down, short selling may be a useful tool. However, you should be aware of the risks associated with this style of trading.
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What exactly is short-selling?
According to Joe Jennings, investment director for PNC Wealth Management in Baltimore, "To short a stock is to sell a security that is not owned by the seller. Shorting is a strategy used to take advantage of an anticipated decline in the stock price."
An investor may borrow shares of stock from a broker and sell them on the open market, creating a short position. At a future date, the investor must re-purchase the shares and return them to the broker, thus closing out the short position, says Jennings. Ideally, the investor would repurchase the shares at a price that is lower than the original purchase price, earning a profit.
Jeffery Born a professor at Northeastern University's College of Business, provides the following example: "If I strongly believed that Facebook is currently over-valued at (approximately) $31.50 per share, I could act on that belief and sell the shares short. If Facebook subsequently declined in price, say to $28 per share, I could buy the shares (and they would be delivered to the individual that the broker borrowed them from) and I would make a profit of $3.50 for each share I sold short, less the transaction cost to sell (short) and then buy (back)."
Can any type of stock be sold short?
"Theoretically, yes. But logistically, no," says Yahoo! finance correspondent Matt Nesto. While it might be easy to short any widely traded stock in the S&P 500, it becomes challenging to find a brokerage firm willing to accept a short trade for an illiquid or thinly traded stock, says Nesto.
Is there a time frame associated with short selling?
Although in theory there is no time limit that accompanies shorting shares of a stock, the lender could conceivably call the shares at will. Additionally, given the interest expense associated with borrowing shares, maintaining a short position for an extended period of time may become costly, says Jennings.
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If you take a gamble, know the risks.
First, Jennings points out that the long term trend of the stock market is to move higher. Not only does shorting a stock involve betting against the fortunes of that company, but also betting against the long term trend of the market in general.
Second, shorting can be expensive. "Typically, the investor shorting a stock must pay interest on the borrowed shares; additionally, the investor is required to pay any dividends to the lender that are earned during the time the stock is shorted," Jennings reveals.
Third, your potential losses are unlimited since you are betting on a stock going down. By contrast, if you went long on a stock, your losses are limited to the amount you lose if the stock goes to zero (plus any additional expenses).
According to Nesto, "The practical risks of shorting are as vast and vague as those that surround any investing." There are lots of events that move the price of a stock higher or lower, including rumors that may not even be true.
So why sell short?
Jennings says there are two main reasons for shorting a stock: speculation and hedging. An extremely risky tactic, speculation involves establishing a short position in an attempt to earn a profit. Hedging is employed to mitigate risk and concerns, establishing a short position in a security to offset a long position within a portfolio.
Likewise, Nesto agrees that many short sales are used as a tool to manage different portfolio risks. "Oftentimes investors will be long and short the same stock as a way to protect a big gain without having to sell. This type of hedging strategy is usually done with put and call options, but the general idea of long and short still applies," he affirms.