How to short a stock
Have you ever wondered how to short a stock? Perhaps you’ve seen movies like The Big Short or The Wolf Of Wall Street and wondered how you can make millions from their strategies. Fortunately, you could earn a lot of money with the help of short selling. Later, you might be surprised to see that it does the opposite of what stock investors usually do!
You perform a short sale or short trade when you think the stock’s price is about to fall. You earn based on how much value the share price loses. However, this is a tricky investment strategy that only experts even dare to do. If you’re not careful, there’s no end to how much money you can lose with a single stock!
We should start by talking about how to short a stock, and then we will cover the benefits of this investment move. Then, we’ll go through the potential risks. If you’re not willing to shoulder the potential losses, we will show similar strategies that may be less risky. All assets have risk, so we cannot guarantee that you won’t lose money in your investments.
How do I short a stock?
We may have presented short selling as a complicated investment move, yet you can do it in a few steps. Here’s how the usual short sale goes:
- Open a margin account – You must open this type of account with your broker. It’s a line of credit you open with them, so you can secure the stocks you will short sell. After all, you’ll be borrowing someone’s assets. Think of it as the collateral you’ll provide, so the lender will feel secure in letting you use their assets.
- Borrow a stock – Look for a stock that is likely to go down in value. Then, speak with your broker about short-selling it. Your broker will find another investor who has those stocks. He will borrow from that investor and promise to return the stocks at a certain date.
- Sell the shares – A short seller buys a stock on margin, and then sells the stocks immediately. You must keep the money from the sale for the next step.
- Wait for a price drop – If you choose the right stock, it should drop in value eventually.
- Buy them again – Once the price falls, it’s time to buy the assets back. You should have some cash left since you’ll be repurchasing them at a lower price. This is otherwise known as closing the short position.
- Return the stocks – You must return the shares to your broker, so you earn from the difference. Congratulations, you now know how to short a stock!
You’ll have to pay fees on that margin account, though. For example, you must pay your broker for finding someone who could lend you stocks. Also, you must pay margin interest every year.
Aside from paying interest, you’ll have to follow certain limits. You’ll have to put at least $2,000 or the total value of the stocks you want to buy with your margin.
Is it a good idea to short stocks?
Here’s the biggest reason why people learn how to learn stocks: quick profits! If you play your cards right, you could earn thousands of dollars within minutes!
Of course, investors have so many other reasons why they short-sell. Contrary to popular belief, it’s not only for profit. Let’s look deeper into the examples:
- Leverage – Your margin account gives you more money to invest, so you could potentially earn more. Also, margin trading lets you access assets you otherwise won’t be able to afford. In turn, you could get more ways of modifying your portfolio.
- Risk management – if you sold short of your current investments, you may compensate for a potential price drop. Let’s say you bought BlackBerry stock, but you’re not sure if the price will go up. It was $12.00 when we discussed it in a previous article, but it was $10.99 at the time of writing this one. Having a short position could mitigate your losses.
- Tax-deductible – Margin interest could offset your taxable income, but you should discuss this with your tax advisor or broker first.
Read More: All You Need To Know About The 2021 Tax Season
What are the risks of shorting stocks?
We should stress just how risky shorting stocks is if you don’t know what you’re doing. Numerous open market conditions could affect stock prices such as the COVID pandemic.
Many stocks are still in freefall as this worldwide crisis continues. Meanwhile, stocks in these sectors are booming due to the changes in consumer behaviors.
Also, sudden shifts in the stock market may bring share prices up and down. For example, AMC stocks were tanking when several Redditors bought them en masse.
This is why learning how to short a stock requires understanding both fundamental and technical analysis. They help you know how the stock may perform in the future.
Still, these methods aren’t foolproof because even veteran investors could make wrong predictions. Here are other risks you should expect from a short sale:
- More losses – Leverage may work against you because it could multiply your losses. If your investments drop to zero, you will have to pay the margin loan balance and interest.
- Margin call – You will get this if the stocks you’re shorting decrease too far. This will trigger a margin call, meaning you will have to sell those shares. In some cases, your broker might sell your investments without telling you first.
- Short squeezes – When you borrow stocks for shorting, you must return them at a specific date no matter what. If the prices don’t fall by then, you will have no choice but to accept losses. Redditors triggered these on meme stocks to get back at rich investors. As a result, they incurred massive losses.
After learning how to short a stock, you may now have an idea whether it suits you or not. If the latter matches you, here are other short-term investments:
- Put options – They work like short sales, but you’re not required to return your stocks. Of course, it has its flaws too. For example, it’s not available for every stock.
- Long positions – As the name suggests, you earn from a stock price increase instead.
- Crypto lending – You could borrow money and provide cryptocurrencies as collateral. If the crypto prices go up, you could leave your crypto loan with profit.
We’ve discussed briefly how to short a stock, but you should further learn about it. As we said, experienced investors are usually the ones willing to perform this method.
This article is just for educational purposes. Plan and research investments yourself. If short selling isn’t for you, choose among the numerous alternatives.
You could learn more about them from the other Inquirer USA articles. They will provide you with an overview of the other assets out there. Don’t short-change your portfolio!