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How an Investor Can Make Money Short Selling Stocks

Tempo de leitura: 5 min

Escrito por
em julho 21, 2021

explain shorting a stock

You can also lose money if the market rises instead of declines as you expected when you initiated the position. This can be particularly problematic and cause something called a “short squeeze” if a large short position accumulates in a stock and significant buying interest subsequently emerges. Retail investors can take action here if they feel comfortable, and they will simply wait as the price declines further. Imagine that the investor has completed steps one and two of the short-sale checklist, borrowing, and then selling the stock they expect to decline. Instead of its shares depreciating, however, the stock experiences a sudden and sharp uptick. Any transaction that bears the potential for high rewards also involves a fair amount of risk, and that’s no different for short sales.

explain shorting a stock

Not only are you paying the stock borrowing fees while you hold on to the position, but the stock could go also continue going up long before starting to decline. It may be easier to understand short selling by considering the following analogy. If the stock goes down, the trader makes a profit, but there are several major risks involved. explain shorting a stock For example, imagine that an investor wants to short a stock that we’ll call ABC company. The investor believes the company is overvalued and the stock will soon head to $8 or lower. There have also been investors who sought to manipulate the price of a stock upward by spreading bullish rumors that turned out to be false.

Costs of Short Selling

Investors are – well, invested in the company they’re purchasing shares of. They have done their homework to learn about all aspects of the company, its mission, its competitors, and the overall climate of its industry. Moreover, this research has provided credible evidence that the company is poised to grow and become more valuable. They rallied together and talked the stock up so much (and bought it up so much) that the buzz spread like a wildfire. The stock soared from around $18 to nearly $350 in less than a few weeks.

All the short seller needs to do to short is to press the sell button in the trading software, then hit the buy button to close the position. When a trader wants to sell a stock short, they must first borrow it from somebody else. They have to borrow shares because when you sell something, you have to have it to sell. The trader then hopes to repurchase the stock at a lower price so they can return the shares to the person they borrowed them from and pocket the difference. SoFi Invest®️ offers access to financial planners and educational resources in order for investors to make better informed decisions.

How to short a stock

A savvy and experienced trader will theoretically be able to identify and seize opportunities for short-sale profits in any market. Yet there are some situations in which the overall market climate is especially amenable to this type of trade. Naturally, time is a pretty broad concept, and in terms of the market, the duration of a long stock can be anywhere from a few minutes to several years. Ideally, the investor sells when they feel they can reap the highest possible profit.

  • This is only possible when the investor has full title of the security, so it cannot be used as collateral for margin buying.
  • If you sell shares that you don’t own, then your sell order initiates a short position, and the position will be shown in your portfolio with a minus in front of it.
  • The massive short squeeze has also bankrupted professional hedge funds that have been short the stock for years.
  • Short selling is a way to make money on stocks for which the price is falling.
  • One famous short squeeze occurred in October 2008, when the shares of Volkswagen surged higher as short sellers scrambled to cover their shares.

When traders believe that a security’s price is likely to decline in the near term, they may enter a short position by selling the security first with the intention of buying it later at a lower price. To set up a short position, traders generally borrow shares of the security from their brokerage. This means that going short requires a margin account, as well as other potential permissions and possible broker fees. Another risk faced by short sellers is a short squeeze in which a stock with a large short interest climbs rapidly in price. This triggers a steeper price ascent in the stock as more and more short sellers buy back the stock to close out their short positions and cap their losses.

What is a short squeeze?

Shorting stock is a popular trading technique for investors with a lot of experience, including hedge fund managers. Selling short on the currency markets is different from selling short on the stock markets. Currencies are traded in pairs, each currency being priced in terms of another. In this way, selling short on the currency markets is identical to going long on stocks. Most brokers allow retail customers to borrow shares to short a stock only if one of their own customers has purchased the stock on margin. Brokers go through the “locate” process outside their own firm to obtain borrowed shares from other brokers only for their large institutional customers.

  • Still, even though short-selling is risky, it can be a useful way to take calculated positions against a particular company for investors who know what they’re doing.
  • Investors must understand that inverse ETFs are designed to be held and traded during a single trading day.
  • If this strategy works, you can make a profit by pocketing the difference between the price when you sell and the price when you buy.
  • Another way to know if it’s a good time to short sell is when the 50-day moving average falls below the 200-day moving average, creating a “death cross.”
  • Unexpected news events can initiate a short squeeze, which may force short sellers to buy at any price to cover their margin requirements.
  • Currently, over half of all Americans over 18 invest in the stock market.

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