Sometimes investors believe that a stock is more likely to drop in value than rise. If that’s the case, investors may profit when a stock’s value plummets by using a technique known as short selling. Shorting a stock is the practice of selling shares that you do not own to make money if the price of the stock you select goes down, but it may also result in a loss if the value of your investment increases.
Why would you short a stock?
Typically, you may short a stock if you believe it is excessively valued or will decline for some reason. Because shorting entails borrowing shares of stock you don’t own and selling them, a share price decrease allows you to repurchase the shares for less money than you originally received when you sold them.
On the other hand, shorting a stock may be useful in various situations. If you own a company in an industry and wish to hedge against an industrywide risk, you can short another firm in the same sector to protect yourself from losses. Shorting a share is often preferable from a tax standpoint than selling your own assets, especially if you expect a short-term share price downturn that will eventually turn around.
To employ a short-selling approach, you must go through a step-by-step procedure:
How to short sell stock in 5 steps
- Pick a stock that you wish to short.
- Ensure you have a margin account with your broker and the appropriate permission to establish a short position in a stock.
- Fill out a short order for the number of shares specified. The broker will front the shares and sell them on the market on your behalf when you submit an order.
- At some time, you’ll need to buy back the stock you sold and then return the borrowed shares to your broker, via your brokerage firm, after closing out your short position.
- If the price of a stock drops, you’ll have to pay less to replace the shares and keep the difference as a profit. If the share’s value rises, it will cost you more to purchase them back and lose money on your short position.
A sample shorting transaction
Here’s how short selling works in practice: You’ve found a stock that is currently priced at $100 per share and believe it to be overpriced. You think the price of this stock will fall soon; therefore, you decide to sell 100 shares of it short. Then, you follow the method outlined above and open a short position.
You’ll get $10,000 in cash from the sale when you short the stock. The broker will deduct their commission from this amount. You’ll receive the same amount of money as any other stock sale, but you’ll also have to pay back the borrowed shares at some point.
Now, suppose the stock drops to $70 per share. You may now close your short position by purchasing 100 shares for $70 each, which totals up to $7,000. When you established the position, you collected $10,000, and your profit is $3,000. Additionally, the broker deducts any transaction costs imposed with the sale and purchase of the shares.
The risks of shorting a stock
It’s essential to remember that the scenario described above occurs if the stock does what you believe it will – fall.
Short selling has several dangers. The most significant hazard is that if the stock price rises significantly, you may find it challenging to cover your losses. In theory, shorting may result in limitless losses — after all, there’s no ceiling on how high a company’s share price might climb. If you lose excessive money, your broker can issue a margin call – requiring you to close your short position by purchasing back the shares at what might be the lowest possible price.
Short sellers must also contend with another problem that compels them to close their positions suddenly. It may be difficult to locate shares to borrow if a stock is a popular target for short sellers. In addition, you’ll have to cover the short if the lender of the stock wants those securities back. In other words, your broker will force you to repurchase the shares before you wish.
Be cautious when shorting a stock
Short selling may be a lucrative technique for earning money if a stock’s value drops. However, it is highly speculative, and only experienced investors should attempt it. Even then, investors should only utilize it as a last resort after carefully considering the associated dangers.