Selling Stock Short – Who Sells Short and How they Profit From It
October 13, 2008
Selling stock short has been in the news a lot recently since stocks across the board have been dropping in price and many speculators have found it a good opportunity to make some money.
Short Selling Example
Short selling is based on the fact that people believe the price of stock will go down. It is easiest to explain with an example, so let us say a short seller thinks company ABC, which is currently at $40, will drop in value.
They could borrow shares of stock from their broker, sell them for $40, and deposit the proceeds in their account. Then, if the stock price goes down, say to $30, they buy back the number of shares they borrowed and return them to their broker. They just made $10 a share, using “borrowed” stock.
Risks of Selling Short
Of course the risk is that the price will go up and the short seller will have to buy back stock at a higher price and lose money. Although the upside is limited to the difference between the stock price when they borrow the shares and $0; the downside is potentially unlimited. The higher the price of the stock goes, the more money the short seller can lose.
There is a tool that short sellers can use called a stop loss order that triggers a stock buyback once the price goes above a certain point. Although it will force them to lose money, the stop loss order will limit the loss.
Short Selling Strategies
Some investors use short selling as a way to offset the risk that stock they already hold will go down. For example, if they own 100 shares of company ABC and are concerned the stock price will drop, they can borrow a certain number of shares of ABC and sell them short. If the stock price plummets and their 100 shares lose significant value, they will recover some of that from the short sale.
Other people sell a stock short simply because they sense an opportunity when a company’s stock price is faltering. Over the last several weeks, when many stocks have been dropping, some traders have used short selling to their advantage. There are claims that short selling contributed to the drastic drop in share price of some of the bank stocks.
The government put a ban on short selling for a few weeks in September to prevent short selling from further eroding the stock market value but that ban has been lifted. If you are thinking of selling a stock short, make sure you’re aware of the potential fees you have to pay the broker and what you are at risk of losing if the stock price goes up instead of down.
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