Things to Consider Before Shorting a Stock

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To a beginning investor , the term short selling may appear like one of those intricate, mysterious strategies that professional traders use to steal freely from others. In reality, anyone can short a stock and generate profit if the stock falls in price. The process of short selling can be of great help in your investment journey, however, you need to understand the operator’s manual before you short sell. If you short a stock the wrong way, then you could easily lose your game in the stock market.

What is Short selling?

Also known as shorting, selling short, or going short, short selling refers to the process of selling something that you do not own. A lot of people are confused how this can be done or why it is allowed. A short seller will sell a stock because he believes that the borrowed stock’s price will fall in the future. Therefore, he sells at a high price in hopes of buying the stock back when the price plummets.

In order to short sell, the short seller needs to borrow the stocks from someone, usually from your broker, who owns it. In return, the short seller pays a fee to the entity lending them the stock. Additionally, if the price of the stock goes up after the short seller sells the stock, they will also be needed to pay a margin to cover the potential loss of the short seller being required to buy the stock back at a higher price. When the short seller purchases back the stock, the stock loan is ended. The difference between the price at which the stock was sold short and the price at which it was bought represents the short seller’s profit (or loss, depending on the case).

Short selling is riskier than buying a stock because the potential losses are unlimited. When someone buys a stock, the highest amount that he can lose is the price they paid for the stock. On one hand, when someone short sells a stock, they lose more as the price of the stock increases.

What to Consider Before Shorting a Stock?

There are some major issues involved with short selling that you must first understand before you attempt to do it. Here are some of the things you should take into consideration before you short a stock:

1. RISK

The maximum you can lose in a long position is 150 percent if you borrowed on margin to leverage your investment. On the other hand, with a short position involving the borrowing of the stock, your theoretical potential loss is infinite.

If you borrow a stock when it is trading at a $10 and the stock runs up to $200, then you are out $190 a share, which means 19 times your original investment. And that is not a good thing.

2. FINDING THE STOCK

You may want to short a stock that is difficult to find. The process of finding shares is called a “locate.” If your broker can’t find them, then you cannot short the stock.

There are some stocks that are hard to short because their shares are not easily available to borrow, which could happen for a variety of reasons. If you are having a hard time to locate the shares to conduct the transaction, it likely means that the stock is not held by a large number of individual shareholders or that there is a large short position in the stock already. It is also virtually impossible to short a stock with a price under $5, and you cannot short a stock within a specified period from its IPO, depending on the exchange the stock trades on.

Short Selling
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3. LIQUIDITY

You should not short a stock that is not highly liquid. Without liquidity, you can be right and wrong at the same time – right about the stock declining but stuck in such a way that you cannot immediately liquidate your short position and get the profits you deserve. Liquidity should be a primary consideration when making short-side positions.

4. Outstanding Short Position

This is the number of shares of a company held short, measured in absolute numbers, or as a percentage of the float of the stock. If this position is large, more than 10 percent to 20 percent of a company’s shares, the word is out and the bad news is already incorporated into the stock price. For the most part, you should avoid stocks with large short positions.

5. MARGIN ACCOUNT

In order to short a stock, you need to open a margin account. The funds from your sale of borrowed stock will be placed on this account. But don’t trust the collecting interest on this money. Not only will your broker charge you on the borrowed shares at the broker loan rate based on the price of the stock when you borrowed it, they will also not pay you interest on the funds in the account or sweep it into a money market fund.

See also Common Types of Investment Accounts

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