Introduction to Stocks
The selling of a security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short.
Short sellers make money if the stock goes down in price. This is an advanced trading strategy with many unique risks and pitfalls. Novice investors are advised to avoid short sales.
To sell short, you borrow shares you don't own from your broker. The moment you get them, you order them sold and pocket the money. Then you wait for the price of the stock to drop. If it does, you buy the shares at the lower price, turn them over to your broker - plus interest and commission - and keep the difference. Buying the shares back is called covering the short position.
Selling short often increases when the market is booming. Often, short sellers believe that a correction - drop in market prices - has to come, especially when the overall economy does not seem to be growing as quickly as stock values are rising.
Risks - The risks in selling short occur when the price of the stock goes up - not down - or when the drop in price takes a long time. The timing is important because you are paying your broker interest on the stocks you borrowed. The longer the process goes on, the more you pay and the more the interest expense erodes your eventual profit.
An increase in the stock value is even greater risk. If it goes up instead of down, you will be forced to pay more to cover your short position than you made from selling the stock.
Squeeze Play - Sometimes short sellers are caught in a squeeze. That happens when a stock that has been heavily shorted begins to rise. The scramble among short sellers to cover their positions results in heavy buying, which drives the price even higher.
Here are a few reasons why short selling might make sense:
1. Some investors are better at identifying overpriced, bad companies than underpriced, good
2. Brokers and analysts focus on what to buy, not what to sell, so the good news is more
widely known than the bad news. When an analyst issues a sell recommendation on a
stock, they find it much harder to get information from the company's investor relations
department, and the analyst's firm would never get an opportunity to raise capital or float a
bond for the company, so they focus more on good news than bad.
3. Many institutions just won't do short selling, leaving unexploited short selling opportunities
from which you can benefit.
4. A portfolio which includes both long and short positions in stocks which tend to move
together will generally have lower volatility than one which has only long positions.
But short selling is not as easy and profitable as it may sound; lots of pitfalls:
1. If the stock price keeps rising, you keep losing. Most short sellers set a limit to how much
they're willing to lose, but then they become vulnerable to a short 'squeeze', in which long
investors buy shares as the stock rises and demand delivery. The danger is that even if the
stock is overpriced, it may become even more overpriced, and you will have to buy it at some
point to cover your position.
2. You're fighting the trend of the market, which is, in the long run, up.
3. SEC rules allow investors to sell short only on an uptick or a zero-plus tick. In other words,
you cannot sell a stock short if it is already going down.
4. Money from a short sale isn't available to the seller, but is escrowed as collateral for the owner
of the borrowed shares. You aren't earning interest on the money.
5. You have to pay any dividends that are earned.
6. You pay the (usually higher) short term capital gains tax on your profits, regardless of how
long you held the short position.
7. Another company could acquire the company you're shorting, possibly at a significant
premium, which would drive up the share price.
Buying Warrants - Like a short sale, a warrant is a way to wager on the future price of a stock, though a warrant is less risky than selling short. Companies sell warrants if they plan to raise money by issuing new stock or selling stock they hold in reserve. A wt after a stock table entry means the quotation is for a warrant, and not the stock itself.
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