What's the Dirt on Short Selling? A Simple Guide to Making Money When Stock Prices Plummet
Short-selling stocks to generate profits for investors
Short selling is a risky, advanced trading technique that lets you make big bucks when stock prices fall. You essentially borrow shares from a broker, sell them at a high price, wait for the shares to drop, and then snag them back at a lower price to return to the broker—pocketing the difference.
The Juicy Deets
- Going Against the Grain: Short sellers wager that a stock's price is gonna drop like a rock. When you short sell, you're betting that you can guess the future better than the rest of the stock market.
- Unlimited Losses, Capped Profits: Unlike most investments, shorting ain't all sunshine and rainbows. You can lose an unlimited amount if the stock's price shoots up instead of tanking, but there's a limit to how much you can profit—up to 100% since a stock's minimum price is zero.
- High Risk, High Reward: Shorting is way riskier than holding stocks for the long haul. That's because your potential losses are unlimited, while the most you can make is limited. It's like playing Russian Roulette with your retirement fund.
Let's Take an Example
Imagine you think Corporation X is too pricy at $200 per share, and its price will take a nosedive. You sneakily borrow some shares, sell 'em at $200, wait for the magic to happen, and then buy 'em back when it hits $125. You'll walk away with a sweet $750 in profit (minus fees and the cost of borrowing the shares).
But if Corporation X's price skyrockets to $250, you'll have to deal with a loss of $500.
The Downsides
- Short Squeeze: When many investors short the same stock, things can get ugly. If the shorted stock suddenly starts surging, short sellers rush to buy back shares to minimize losses. This buying frenzy drives the stock price even higher.
- Margin Call Risk: You can only short sell using a margin account, which your brokerage will lend to you to invest in securities. If the stock you've shorted takes a dramatic turn for the worse, the brokerage might force close your position and dip into your savings to cover the losses.
Why'd They Go Short?
Smart cookies use short selling to make a quick buck or to protect their portfolio.
Speculation: They believe a specific security or the entire market will take a dive.
Hedging: To safeguard gains or cut losses in a security or portfolio by using the shorting strategy as a form of insurance.
When to Go Short?
Short selling only makes sense if you have a crystal ball showing you a stock's price will plummet. There could be a number of reasons for this view—dismal company news, overvaluation, market downturns, or the belief that a hot stock or sector can't keep flying high forever.
However, shorting carries immense risk since losses can pile up without limits. And instead of just investing and chillin', you gotta keep an eagle's eye on your short positions and be prepared for a short squeeze, which can lead to shocking losses. So unless you're a Wall Street shark with a taste for high-risk adventures, just stick to buying stocks.
Regulatory Shenanigans
Short selling has always been a bone of contention, with some folks crying foul about people profiting when others suffer. Regulators have jumped in to maintain order and protect investors. In the US:
- The Alternative Uptick Rule: This rule permits short selling only when the price of a security has climbed by 10% or more.
- Regulation SHO: Requires brokers to have reasonable confidence they can borrow the security before okaying a short sale. This rule also bans "naked" short selling—selling shares you don't own.
- Threshold Securities List: This is a list of securities with reported failures to deliver for five or more consecutive trading days, used by regulators to spot potential market manipulation.
- New Reporting Requirements: Starting in 2023, investors will need to report their short positions, and brokers will be required to track all activity and share the data with the Financial Industry Regulatory Authority (FINRA).
A Safer Short Game
If you smell the danger of short selling, you can try buying a put option instead. This option gives you the right to sell the underlying stock at a specific price, protecting you from losses if the stock price falls, but not giving you the upside potential if the stockprice rises.
But, beer buddies, remember that this guide is just a starting point for understanding tricky short selling. tanks for coming along on this wild ride with me!
- During a bear market, short selling could be an attractive investment strategy with potential profits, as one can sell overvalued stocks and buy them back later at a lower price.
- The Initial Coin Offering (ICO) market seemed to follow the stock market trends, experiencing a bear market during market downturns, where tokens' prices plummeted, creating opportunities for short selling.
- The increasing regulation in the crypto finance sector, such as the Alternative Uptick Rule, Regulation SHO, and Threshold Securities List, aimed to ensure liquidity and fairness in the market, protecting investors from manipulations and potential losses, even in shorting activities.
- The bear market in the stock-market could cause traders to start re-evaluating their short positions and looking for safer alternatives, such as purchasing put options, which offer protection from losses on falling stocks without the potential for profits if the stocks rise.
- Despite the high rewards of short selling, the immense risk of unlimited losses and the increased monitoring by financial regulators have led some investors to question the wisdom of relying heavily on this strategy for their investment portfolios.
