Short Selling
Date Added: January, 2001
By Chris Stallman
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I have
found myself receiving a number of questions involving selling a
stock short but I have been hesitant to answer them, and I'll
explain why later in the article. If you do intend on using this
investing technique, I strongly urge you to read the entire article.
When we hear stories
of people making money in stocks, we have these pictures in our
heads of them buying the stock dirt cheap and selling it for much
more than they bought it for. But this isn't the only way. Another
way people can make money with stocks is to buy them when they're
high and sell them when they're low and it's called short
selling. I know, this all sounds crazy but it is actually possible.
Selling
a stock short basically means that you buy the stock when it's
high with the intention of selling it when it's lower. The way
this works is that the investor makes a "short" trade
with his broker. This trade tells the broker to lend the investor
a certain amount of shares at the current price. Rather than keeping
these shares held in an account, they're sold immediately and
the investor is given the value of how much they are worth. So it
sounds like free money, right? Not quite. The investor still has
the liability to return these shares to the broker. When the investor
thinks that the stock is low enough, he puts in a "short cover"
order with his broker that allows him to buy back the shares. He
or she then returns the shares to the broker and keeps the difference
between the price he originally sold it for and what he bought it
back for. I know I know, it's confusing. So here's an example:
John decides that he thinks XYZ stock is ready for
a fall so he goes to
his broker and shorts 20 shares
at $50/share. That means he has
$1000 in his account. The stock
drops down to $40/share and he
decides he wants to buy them
back to return them to the broker so he
buys 20 shares at $40/share for
$800. He then returns them to the
broker and keeps the $200 difference.
It sounds pretty good at first but you should be fully
aware of the risks before you decide to do so. The largest risk
that you have is for the stock goes up. If John's stock would
have went up to $60/share, he would have had to cough up $200 out
of his own pocket just to return the shares.
Anytime there's money to be made, there's also
money to be lost. And with short selling, you can actually lose
more money than you originally invested. For example, if John kept
holding XYZ stock and it skyrocketed to $150/share, he would have
to buy the shares back and that would cost him $3,000. That means
he would have lost $2,000 even though his original investment was
only $1,000. However, John can balance out his risk by using buy
and sell orders with his trades. By doing this, he can reduce a
lot of the risk involved with short selling.
Short selling is mostly for the short-term investor
and I encourage you to stick to the long-term approach. It may not
be as exciting but it gets the job done. If you do decide to short
some stocks, do all the research you can to be absolutely sure that
the stock WILL go down and then use stop orders to prevent yourself
from losing too much money.
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