Short selling can generally only be undertaken in a margin account , a type of account by which brokerages lend funds to investors and traders for trading securities. Therefore, the short seller has to monitor the margin account closely to ensure that the account always has sufficient capital or margin to maintain the short position. If the stock that the trader has sold short suddenly spikes in price for example, if the company announces in its quarterly report that earnings have exceeded expectations , the trader will have to pump additional funds into the margin account right away, or else the brokerage may forcibly close out the short position and saddle the trader with the loss.
If an investor shorts a stock, there is technically no limit to the amount they could lose because the stock can continue to go up in value indefinitely. In some cases, investors could even end up owing their brokerage money.
Short selling can serve the purposes of speculation or hedging. Speculators use short selling to capitalize on a potential decline in a specific security or across the market as a whole. Hedgers use the strategy to protect gains or mitigate losses in a security or portfolio. Notably, institutional investors and savvy individuals frequently engage in short-selling strategies for both speculation and hedging simultaneously.
Hedge funds are among the most active short-sellers and often use short positions in select stocks or sectors to hedge their long positions in other stocks. Though short selling does present investors with an opportunity to make profits in a declining or neutral market, only sophisticated investors and advanced traders should attempt it due to its risk of infinite losses.
Short selling is not a strategy many investors use, largely because the expectation is that stocks will rise in value over time. In the long run, the stock market tends to go up, although it is occasionally punctuated by bear markets in which stocks tumble significantly. For the typical investor with a long-term investment horizon, buying stocks is a less risky proposition than short selling.
Short selling may only make sense in certain situations, such as in a protracted bear market or if a company is experiencing financial difficulties. That said, only advanced investors who have a high tolerance for risk and understand the risks associated with short selling should attempt it. Trading commissions are not the only expense involved when short selling. There are other costs, such as:. Yes, you can lose much more than you have invested in a short sale; in theory, your losses can be infinite.
This is the reverse of a conventional "long" strategy, by which the maximum gain on a stock you have purchased is theoretically infinite, but the most you can lose is the amount invested. As an example of the devastating losses that can be inflicted on a short sale by runaway price appreciation, consider this situation.
An investor who had a short position of shares in GameStop as of Dec. Short selling has acquired a negative connotation because some unscrupulous short sellers have used unethical tactics to drive down stock prices.
But we've all been reminded in the past year that in the short run, stocks can go down -- sometimes quite sharply. Obviously, someone profited from this recent downturn; those who bet against the market likely made out pretty well. While few among us can expect to profit that handsomely from betting against the market, we do have a number of tools available to make money in a down market. Let me "put" it to you this way The simplest way to bet against a stock is to buy put options.
To review, buying a put option gives you the right to sell a given stock at a certain price by a certain time. For that privilege, you pay a premium to the seller "writer" of the put, who assumes the downside risk and is obligated to buy the stock from you at the predetermined price.
Got all that? OK, let's try an example to illustrate. This leverage allows you to reap outsized rewards if you're correct; if you're wrong, the most you'll lose is the premium paid. The put strategy also allows you to make bearish bets against indexes and sectors by buying puts on exchange-traded funds that track them.
Why not just short? In a nutshell, a put is a contract that gives you the right to sell stock at a fixed price for a certain time period.
For example, if you owned shares of Netflix stock and purchased a put option contract that expired 6 months from now, you would have the right to sell your stock at a fixed price anytime between now and then. Even if Netflix crashed to zero during that time frame, you would still have the right to sell your stock for the agreed upon price!
When traders believe a stock will fall lower, they can borrow shares and sell them with a view to buying them at lower prices later on. To bet against Alphabet stock , for example, you would short Alphabet at the current share price in the hopes that, when the price fell, you could buy it back buy-to-cover is the terminology used for a profit. The kicker is if you are wrong, you risk losing a lot of money. Simplified Financial Newsletter.
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