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Last Tips & Tricks

What is a short sale?

Stock investing tips by Mike Langevin  


You may have been convinced that the price of a stock was overvalued and hoping that you could take advantage of this to increase your portfolio balance? Many investors are taking advantage of this situation to make money with a strategy that we call’ ” short selling”

Short selling is not a very complicated strategy, but it is a concept that many investors are struggling to understand. Under normal circumstances an investor tries to make money buying at a low price and selling at a higher price, going short is the complete opposite, the investor will sell the shares in order to repurchase them at a later date at a reduced price (covering) and keeping the difference.Here’s how it works.

When you short sell a stock, your broker will lend you the shares that come from his inventory, or another broker’s. The shares will be sold immediately and the money resulting from the sale will be deposited into your account, however, the broker will ask for additional collateral to protect themselves in the event you need to buy the shares at a more expensive price and take a loss. There is no time limit to maintain a short position, but sooner or later you will have to return the shares to your broker through a purchase that you must make, this is what we call” covering”. If the price has dropped from when you sold the shares then the buyback you make at a lower price will generate your profit. If you need to buy the shares at a higher price, you will lose money.

Consider an example.An investor believes that the stock of the company ABC is about to fall, so he goes to his broker and shorts 100 shares of ABC at $ 20 a share. This means that he receives $ 2,000 for the sale and this is deposited into his account. Our investor was right and the stock price falls to $ 10. So he decides to buy the 100 shares back at $ 10 for a total cost of $ 1,000. He then returns the shares to his broker and keeps the difference which is $ 1,000.

In this example everything is perfect, but you must be aware of the risks that you incur in performing such a strategy. In a negative scenario, if the shares were to rise to $ 30 and you decide to buy the shares back at this price, you would be paying 30$ a share for a total of 3,000. Returning the 100 shares back to your broker would result in you taking a loss of $1000The pros of short selling

- Even though the long term trend of the markets is rising, the share price will fluctuate and short selling stock can be a way to make money when a stock is overvalued or that a company is struggling.

- In a large portfolio of long positions, shorting can be a strategy of protection against a sharp market downturn.

- As you sell the shares you borrow from your broker, Short selling does not require any down payment when you already have a portfolio as collateral. The proceeds of the sale, however, must remain in the account to meet    margin requirements. The money could also be used to purchase additional shares, as long as you comply with margin requirements.

- Some brokers even offer interest on money received from the sale of shares that are sold short.

Cons of short selling

- As the share price could potentially rise dramatically, the potential loss of a short sale is unlimited. In reality, you would repurchase the stock before an exuberant loss occurred or your broker would liquidate the stocks if margin requirements were not sufficient.

- You can not make more than 100% with a short position. The share price can not go below zero.

- As you are the borrower of the stocks, you are responsable for paying any due dividends. This amount will generally be deducted from your account.

- Certain stocks can not be sold short. To short a stock, your broker must hold an inventory of said stock so that he can lend them to you. Some stocks, such as penny stocks are often difficult to short due to the low number of    shares outstanding.

- It is also possible that overnight your broker requires you to dispose of your shares when he no longer possesses enough stock of the company in his inventory to satisfy all its customers who are short. When a large amount of  shares are required to be repurchased, it creates an event that we call a short squeeze. This can cause a sudden and rapid rise of the stock price if many investors scramble to cover their stock ownership.

Short selling is one of the trading strategies that involves risks, so every investor should be well aware of the process, their involvement and take the necessary steps to properly manage their portfolio and limit their losses. It is however a technique that can add diversification to a portfolio.

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