Did you know that there is a way to short stocks so your trade becomes profitable when the price of the stock goes down? This can be done by short selling stock. I will explain how it works below, and it may be a little confusing at first.
When you short sell a particular stock, your stock broker lends the stock to you. These shares are then sold and the funds from the sale are credited to your trading account.
A stock broker will usually sell the stock from another traders account, their own inventory or a different broker.
When you want to close the trade, you effectively buy back the stock. If at the time of closing the trade, the value of the stock is higher, it will cost you more to buy back, you will lose the difference. If the stock price has fallen, the difference in price will be your realized profit.
What about dividends?
As you probably know by now, when you buy shares in some companies, they pay out a regular dividend. Remember, as I mentioned earlier, when you are short selling stock, you borrow the stock from an individual or broker and due to this you will need to pay the lender of the stock the dividend.
There is no time limit for shorting stocks. However, if you are trading with a margin account, interest charges keep rising the longer you hold the trade, so it is important to keep this in mind when using a margin account.
There is also the possibility that the broker may need the stocks back that they lent you. Perhaps the client they borrowed it from wants to close their trade.
In this situation, your broker will need to find the stock from else ware or you will have to cover (hedge) until it can be found.
This is quite a rare occurrence and is known as being “called away”.
What is Naked Short Selling?
Don’t be alarmed, naked short selling does not involve sitting at your computer with no clothes on!
The practice involves short selling a stock without you needing to borrow it. You will still be required to pay for the dividend in this case.
In many circumstances naked short selling is illegal. This is because it provides the opportunity for a stock price to be manipulated.
If you like you can see what the SEC has to say on the matter you can see their stance here.
Is shorting stocks risky?
Yes, short selling stock is very risky. Shorting stocks is considered to be a high risk endeavor, and it is a high risk/reward way to trade.
When you buy stocks, you know the most you can lose is 100% of the value of the stock you buy. This is not the case when shorting stocks. The downside risk has the potential to be unlimited.
To control risk, it is often important to use stop losses and only risk a small percentage of your account on each trade.
Don’t forget, you may also have to pay for the dividends on the shares you borrow as well. Shorting stocks is often only suitable for highly experienced traders who’s research and market insight has given the investor reason to believe that a particular stock may be overvalued.