Investing in Stocks

In the traditional world of buy and hold investing you buy a stock and hold it until it increases in value. It doesn't get much simpler than that. But, what about the times you come across a stock that you wouldn't buy even in an investment game? You know that the stock is doomed, a sure loser. If you were confident that the stock price was going to fall wouldn't it be nice to be able to profit from the decline?

Well you can profit from the decline of a stock and though it may be simple it is not necessarily easy. There are substantial risks and pitfalls that you need to watch out for. The mechanics of a short sale are somewhat complicated and the investor's risks are increased so it is important that you understand the transaction before getting into the trade. Lets take a closer look.

What is Short Selling?

If you are bullish on a stock and you think that it is going to go up in value, by purchasing the stock, you are considered "long" the stock. But if you anticipate a decrease in stock price you are referred to as bearish on the stock. To profit from the stock price falling, you can borrow the stock and sell it, by selling the stock you did not own you are considered "short" the stock. A person who "short sells" or "sells short" or simply "shorts" a stock will borrow shares in hopes that the stock will decrease in value, allowing them to purchase the stock at a lower price in the future and replace the borrowed shares. It may sound a little confusing but it's actually a simple concept. Essentially, you are selling the stock first and buying it back later. Although shorting stocks can be a little intimidating for new investors, short selling offers a great opportunity to profit from a bear market, a decreasing stock price, or even to hedge against uncertain market conditions.

Here is an example: You tell your stock broker that you wish to short 100 shares of XYZ stock. When an investor "sells short" a stock, a broker either lends him the stock or borrows it from another customer or brokerage firm in order to deliver the shares to you. Your broker will sell your borrowed stock and place the money from the sale in your account. Your hope is that the stock price will plummet and you can replace the 100 shares of XYZ at a much lower price. Your profit will be the difference between the initial price that you sold at and the price you bought at. Because you borrowed these shares you now owe back the lender the same number of shares sometime in the future. Furthermore, you must pay the lender of the securities any dividends or rights declared on the stock during the course of the stock loan if any of these occur during the time you short the stock.

Like most financial transactions, shorting stocks is subject to certain restrictions. These restrictions include the size, price, and type's of stocks. For example you may not sell short penny stocks and most short sales need to be done in round lots. In addition, short sales must be made in a margin account and the transaction is always done at a higher price than the previous sale (a "zero plus tick"). This is to prevent manipulation of the stock price.

The Transaction

After you have completed your research and analysis you think that company XYZ has a poor outlook in the coming months. Right now the stock is trading at $65, but you foresee it trading much lower than this price in the near future. Since most short sales require a minimum transaction of 100 shares you decide to take the plunge, one of two things can happen in the coming months. Let's step ahead two month's and cover both scenarios.

SCENERIO 1: You Make Money
(The stock falls from $65 to $40)
You borrowed 100 shares of XYZ at $65 $6,500
You buy back 100 shares of XYZ at $40 -$4,000
Your Profit/Loss $2,500

SCENERIO 2: You Lose Money
(The stock climbs from $65 to $85)
You borrowed 100 shares of XYZ at $65 $6,500
You buy back 100 shares of XYZ at $85 -$8,500
Your Profit/Loss -$2,000

Clearly, short selling can be profitable as shown in Scenerio 1. But nevertheless, the strategy has its risks because there is no guarantee that the stock price will drop, as you can see in Scenerio 2. If the price climbs instead, the investor still has to replace the stock that was borrowed and will have to pay the higher market price to buy the stock back. The market price could be substantially higher as there is no limit on how high a price may rise. Let's take a look at the risks...

The Risks

Potential Risks from Short Selling
  1. Stocks in general have an upward drift, this means that in the long run most stocks will rise in price. So in a sense you are betting against the overall direction of the market.

  2. When you short sell your loses are infinite. Short sellers lose when the stock price rises, and a stock is not limited on how high it can rise whereas it can only go as low as zero.

  3. Shorting stocks involves margin - borrowed money. Therefore it is easy for losses to get out of hand, you must maintain the proper collateral (around 50% of the value) otherwise you will be subject to a margin call.

  4. The dreaded "short squeeze". If a stock starts to rise rapidly in price it can easily escalate if short sellers want out. Lets say the stock rises 15% in one day, those with short positions may be forced to liquidate and cover their position by repurchasing (replacing) the stock. If enough short sellers buy back the stock it can push the price even higher, forcing more short sellers to cover their positions!