Most people think the only way to earn a profit from the stock market is by buying stocks and allowing them to increase in value over the course of a few months or years. Once the stock has reached its desired level of return, they sell and earn a tidy sum. What many people don’t know is that you can also profit from the stock market even when the market is in decline, which goes the opposite of what many individuals know. The way investors can make money with a declining stock market is thru an investment strategy called shorting. So, what is shorting, what is its history, its risks, and how does it work? Read more to learn how.
Although the invention of shorting is debatable, it was likely invented by Isaac Le Maire, who was a Dutch businessman and shareholder in the Dutch East India Company in 1609 and has been used by investors to make a profit from declining shares ever since. So, how does it work?
Overview
On the surface, investors that can predict the price of a stock decreasing are able to earn a return that is the difference between the higher price at which they shorted and the lower price they sold at. For example, an investor purchases a share in XYZ at a price of $10. One month later, the share is trading at $5 and if the investor chooses to sell at this price point, they will have earned $5. So, what happens if the stock price increases? Same scenario as above, but instead of the stock price decreasing to $5, the stock price increases to $15. In this case, the investor has a loss of $5
Technical Aspects
The process of short selling is different than buying stocks in that, the stocks are purchased like any other asset. Short selling on the other hand involves borrowing the shares from an investor or institution and then selling them as soon as they are received. The investor will then buy the shares back later for less than what they have received.
For example, an investor predicts that shares of XYZ will decline in the future and wants to short the stock. They borrow a share valued at $20 send then sell it for $20. This also means they are in debt for one XYZ share, not the value of the share, only that they need to give back one share. At a later date, the share price has declined to $10. After the decline, the investor buys the share at $10 and then pays off the debt of one share owed, earning a profit of $10.
The opposite is when the share price increases instead of decreases. For example, the investor borrows a share at $20 then sells it on the market. After which, the price of the share increases to $30. In this case, the investor is then forced the buy the share at $30 and then cover the debt, which is one share. In this example, the investor has a loss of $10.
Getting Started with Short Selling
When it comes to short selling, you will need an additional feature in your brokerage account, which is a margin account. Unlike a typical brokerage account, a margin account can hold mutual funds, bonds, stocks, and even cash as collateral. This is done so that if an investor is unable to pay the balance if the stock price drops too low, the brokerage can recoup some capital from the losses. You will also be charged an interest rate on the shares that are outstanding until the shares are returned. The interest rate varies from one brokerage to another.
Short selling is more in line with speculative trading as opposed to other types of trading and involves significantly more risk than traditional trading. However, you can increase your chances of having successful short sales thru various means by finding the short-sale target. There are three main ways of increasing short-selling success, which are technical analysis, thematic and fundamental analysis.
Technical Analysis: The analysis strategy finds financial patterns in the data of the market to find and identify potential movements in the price of the stock. One of the most common ways of finding stocks that are declining through the technical analysis is by searching for lower lows, while at the same time the stock is trading at higher volumes than before.
Thematic Analysis: This strategy is simpler than the other two and does not involve many technical aspects. This is mainly because it relies on shorting companies that are operating in outdated industries or business models. It can be costly to hold the shares of a company for a long period of time due to brokerages charging interest rates and assuming the specific company does not change its course and updates its model or technology.
Fundamental Analysis: Looking at a company’s balance sheets can allow an investor a sneak peek into how the company is being run and whether there is a chance to decline in price. For example, a company that is a good candidate for shorting may have a declining Earnings Per Share (EPS) and revenue.
Protecting Yourself and Your Returns
Before entering any trade, you need to determine your entry points and exit points, which are the price points at which you will purchase the shares and when you will sell. You can do this with buy-stop orders, which get triggered to buy the shares back once the price is at or above the stop price that you have entered.
Another way to protect returns is by using trailing buy-stops. This financial strategy specifies a stop price that “trails” the lowest price by a certain amount or percentage that is predetermined by the investor. If the stock price increases above its lowest point by the trail, the order is triggered and then shares are purchased. However, if the stock price declines, the stop resets at a lower price.
Understanding the risks
The risks with short selling are much greater than typical stock trading. The worst-case scenario when buying stocks is you lose 100% of your investment. But with shorting, the losses can be limitless in theory. This is due to the investors being required to buy the shares to cover the debt and if the share price keeps increasing, then the investor is forced to buy the stock at any price.
Another aspect of margin accounts is a margin call. If the total value of the collateral in your account dips below the minimum required set by the brokerage, your brokerage can and will require you to deposit more capital into the account or sell your positions to cover the losses.
Conclusion and Summary
As with all investing, it is highly advisable that investors do all the due diligence they can, whether they are going long on positions or shorting. However, the losses when it comes to purchasing stocks are limited to the value of the stocks, but the losses are, in theory, limitless when it comes to shorting. It is vital that investors have enough experience in stock market trading and financial strategies before taking on shorting.
Going long on stocks can be more straightforward and involve less speculation than shorting. Traditional stock trading is quite regulated, but the shorting industry is subject to extra scrutiny, controversy, and regulations due to its impact on the overall market, with some governments banning the practice temporarily. This post was written by Financialquazar on Fiverr. We hire Fiverr writers who are proficient in the subjects that are important to understand that that we can all learn more. To read more from Financialquazar check out What is an IRA and How to Invest with an IRA and Asset Allocation.
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