Not all stock trades are straightforward buys or sells. There are several strategies you can use to increase your gains, though they also increase your risk of incurring losses. Among these strategies is selling short.
Typically investors sell short to hedge their portfolios against potential losses from other stocks they own. But speculators may sell short expecting to realize a profit from a major drop in a stock’s price.
How selling short works
While most investors buy stocks they think will increase in value, others invest when they think a stock’s price is going to drop, perhaps substantially. What they do is described as short selling.
To sell short, you borrow shares you don’t own from your brokerage firm and give a sell order. The proceeds are held in escrow until the shares are returned. Then you wait for the price of the stock to drop. If it does, you buy the shares at the lower price, return them to the firm (plus interest and commission), and your account is credited with the difference.
For example, you might sell short 100 shares of stock priced at $10 a share. If the price drops, you buy 100 shares at $7.50 a share, return them, and keep the $2.50-a-share difference — minus fees and commission.
Buying the shares back is called covering the short position. In this case, because you sold them for more than you paid to replace them, you made a net profit.
What are the risks?
The risk in selling short is that the price of the stock goes up — not down — or that the drop in price takes a long time. The timing is important because you’re 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 potential profit.
An increase in the stock’s value is an even greater risk. If the price goes up instead of down, you will be forced sooner or later to pay more to cover your short position than you made from selling the stock. In fact, you can have a major loss.
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.
Like a short sale, a warrant is a way to wager on the future price of a stock — though buying a warrant is definitely less risky. Warrants guarantee, for a small fee, the opportunity to buy a stock at a fixed price during a specific period of time. Investors buy warrants if they think a stock’s price is going up.
For example, you might pay $1 a share for the right to buy a stock at $10 within five years. If the price goes up to S 14 and you exercise, or use, your warrant, you save $3 on every share you buy. You can then sell the shares at a higher price to make a profit ($14 – ($10 + $1) = $3), or $300 on 100 shares.
Companies sell warrants if they plan to raise money by issuing new stock or selling shares they hold in reserve. After a warrant is issued, it can be listed and traded like other investments. A wt after a stock table entry means the quotation is for a warrant, not the stock itself. If the market price of the stock is below the set price when the warrant expires, the warrant is worthless. But since warrants are fairly cheap and have a relatively long life span, they are traded actively.
Who’s the lender?
Selling short often increases when the market is booming. Short sellers believe that a correction, or drop in market prices, has to come, especially if the overall economy does not seem to be growing as quickly as stock values are rising. But short selling is also considered a bullish sign, or a predictor of increased trading, since short positions have to be covered.
You might wonder where brokers find the stocks to lend their clients who want to go short. While they may tap their firm’s inventory of shares, they are more likely to borrow from other investors’ margin accounts or from shares held in institutional accounts, such as mutual fund portfolios or pension funds.
There’s a certain lack of transparency, in the sense that the actual shareowners may never be aware that their shares have been loaned. On the one hand, that’s not really a problem. Their ownership is not at risk because brokers who act on short-sale orders hold the proceeds from the sales in escrow on behalf of the lender until the shares are returned.
But while the shares are safe, there is a potential downside to being a lender that may take you by surprise. Any dividends paid on your shares during the time they are on loan are taxed at your regular federal tax rate rather than the lower long-term capital gains rate that applies to qualified dividends. You may also be unable to vote on corporate issues with other company shareholders if that vote occurs when your shares are on loan.
These rules have prompted some investors to limit their use of margin accounts if they aren’t doing a lot of margin buying or short selling. Or they may be careful to deposit only non-dividend-paying stocks to meet the required minimum for being able to trade through the margin account.
What Is Short Selling Stocks? Meaning And Examples by Inna Rosputnia
Wishing you a great week!
Want Your Money To Grow?
Subscribe to get free research, trading lessons, and more insights.
(We do not share your data with anybody, and only use it for its intended purpose)