If you’ve ever lost money on a stock, you’ve probably wondered if there’s a way to make money when stocks fall. There is, and it’s called short sale. While this seems like the ideal strategy for taking advantage of falling stock prices, it still carries more risk than buying stocks the traditional way.
Key points to remember
- Shorting stocks is a way to profit from falling stock prices.
- A fundamental problem with short selling is the potential for unlimited losses.
- Short selling is usually done using margin and these margin loans come with interest charges, which you have to pay while the position is in place.
- With a short circuit, no matter how bad a company’s outlook may be, there are several events that could cause a sudden reversal of fortune.
How the short circuit works
The motivation behind shorting stocks is for the investor to make money when the stock price goes down. This is the opposite of the “normal” process, in which the investor buys a stock with the idea that it will rise in price and be sold at a profit.
Another distinguishing feature of short selling is that the seller sells a stock that he does not own. In other words, they sell a stock before buying it. To do this, they must borrow the shares that they sell to the investment broker. When they do, they sell the stock and wait for its price to (hopefully) drop.
At that point, they can buy the stock for delivery and then close the short position with a profit. You might be wondering what happens if the stock price goes up and that is an important question. The seller can choose to stay short until the stock price drops, or they can close the position at a loss.
Short Selling Risk vs. Reward
A fundamental problem with short selling is the potential for unlimited losses. When you buy a stock (go long), you can never lose more than your invested capital. So your potential gain, in theory, has no limit.
For example, if you buy a stock at $50, the maximum you can lose is $50. But if the stock goes up, it could hit $100, $500, or even $1,000, which would be a big return on your investment. Momentum is the exact opposite of a short sale.
If you sell a stock short at $50, the maximum you could earn on the trade is $50. But if the stock goes up to $100, you will have to pay $100 to close the position. There is no limit to the amount of money you could lose on a short sale. If the price were to reach $1000, you would have to pay $1000 to close a $50 investment position. This imbalance helps explain why short selling isn’t more popular than it is. Wise investors are aware of this possibility.
Time is working against a short sale
There is no time limit on how long you can hold a short position in a stock. The problem, however, is that they are usually bought using margin for at least part of the position. These margin loans come with interest charges and you will have to keep paying them as long as your position is in place.
The interest charged works like a kind of negative dividend, in that it represents a regular reduction of your capital in the position. If you pay 5% per year in margin interest and hold the short position for five years, you will lose 25% of your investment just doing nothing. This stacks the deck against you. You won’t be able to sit in a short position forever.
There’s more news on the margin front, and that’s both good and bad. If the price of the stock you are selling short goes up, the brokerage firm may set up a “margin call“, which is a requirement for additional capital to maintain the minimum investment required. If you cannot provide additional capital, the broker may close the position and you will incur a loss.
As bad as it sounds, it can work as a sort of stop loss arrangement. As already mentioned, the potential losses on a short sale are unlimited. A margin call effectively limits the loss your position can sustain. The main disadvantage of margin loans is that they allow you to leverage an investment position. While this works brilliantly on the upside, it simply multiplies your losses on the downside.
Brokerage firms generally allow you to margin up to 50% of the value of an investment position. A margin call will generally apply if your equity in the position falls below a certain percentage, typically 25%.
Factors that can hinder a short sale
No matter how bad a company’s outlook may be, there are several events that can cause a sudden reversal of fortune and push the stock price higher. No matter how many searches you do or how much expert advice you get, one of them can pop up at any time.
If this happens while you are holding a short position in the stock, you could lose your entire investment, or even more. Examples of such situations are:
- The general market could rise significantly, driving up your stock price, despite weak company fundamentals
- The company could be a candidate for a takeover – the mere announcement of a merger or acquisition could send the stock price skyrocketing
- The company could announce the unexpected good news
- A well-known investor could take a large position in the stock, if they believe it is undervalued
- The news could break about a major positive development in the company’s industry that will drive the share price higher
- Political instability in a certain part of the world could suddenly make your short selling company more attractive
- A change in legislation that affects the company or its industry in a positive way
These are just a few examples of events that could occur and cause the stock price to rise, despite extensive research indicating that the company was an ideal candidate for a short sale.
Investing in stocks in the usual way is risky enough. Short selling should be reserved for very experienced investors with large portfolios that can easily absorb sudden and unexpected losses.
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