For example, if you think the price of a stock is overvalued , you may decide to borrow 10 shares of ABC stock from your broker. You'll have to pay a higher price to repurchase the shares and return them to the broker's account. Calculating profit for a short sale is slightly more complex. You would pay a small commission for the trade, which would come out of your profit.
Depending upon timing, you might also have to pay dividends to the buyer of your shares. When you short a stock, you expose yourself to a large financial risk. One famous example of losing money due to shorting a stock is the Northern Pacific Corner of Some of the wealthiest men in the United States went bankrupt as they tried to repurchase shares and return them to the lenders from whom they had borrowed them. If you want to sell stock short, do not assume you'll always be able to repurchase it whenever you want, at a price you want.
Stock prices can be volatile. When investing, you should never assume that for a stock to go from price A to price C, it has to go through price B. The market for a given stock has to exist. You may end up losing significant money if:. In theory, the risk of losses on a short sale is infinite.
A stock price could continue to rise with no limit. The short selling tactic is best used by seasoned traders who know and understand the risks. In theory, you can short a stock as long as you want. In practice, shorting a stock involves borrowing stocks from your broker, and your broker will likely charge fees until you settle your debt.
Therefore, you can short a stock as long as you can afford the costs of borrowing. The opposite of shorting a stock is " going long. That is, short-selling. It generally involves selling borrowed shares of a stock with the belief that the price will drop, at which point you'd buy shares at a lower price to repay what you borrowed more farther below. And it's not the province of just hedge funds or other large investment entities.
Individual investors — for better or worse — can employ it, too, if their brokerage approves it. More from Personal Finance: Here's a decade-by-decade guide to retirement planning Why to be cautious before investing in cryptocurrency Here's a month roadmap to financial wellness. Retail investors, led by those in the WallStreetBets Reddit chat room, have been piling into Gamestop , AMC Entertainment and other stocks that hedge funds were counting on going lower.
In a nutshell: All the buying pushed up the prices, meaning the funds' bets were wrong and they've lost billions of dollars. While this group is demonstrating how retail investors can hit hedge funds where it hurts, the ongoing battle also shows how risky short selling is.
Essentially, a put option gives you the right, but not the obligation, to sell a stock at a predetermined price known as the strike price at any time before the option contract expires. So, the idea behind buying a put option is similar to shorting, although the most you can possibly lose is what you pay for the put option.
Now, there's more to trading options than I can explain here, so do your homework if this is a strategy that sounds appealing to you. But it can be a smart alternative to the unlimited loss exposure that comes with shorting a stock.
Her areas of expertise and research interest include legal and ethical issues in financial markets, entrepreneurial finance, and regulation of financial markets around the world. The Motley Fool: What are some common misconceptions about short selling that investors should know? Johan: I think most investors believe the risks to be the same as that of taking long positions. Definitely not the case. Some risks are, of course, similar, for example trading on misinformation.
Short sellers have an incentive to provide false information to push stock price down but remember that for short sellers there is the added cost of borrowing the stock that they have to consider when they succumb to herd mentality. This isn't a new game. Having voting rights due to long positions that enable them to facilitate stock price movements and having setting off capabilities with short positions make for potentially high volatility. As I mentioned earlier, the market may not be as efficient as the less sophisticated investor thinks.
For example, take naked shorts. If the seller never intends to deliver, then theoretically the seller could sell as many shares as the seller wants -- possibly 10 times more than the actual number of floated shares and drive the price down to zero -- until market regulators step in.
Discounted offers are only available to new members. Stock Advisor will renew at the then current list price. If it does, the trader can buy the shares back at the lower price, return them to the brokerage and keep the difference as profit.
Investors may use a shorting strategy as a form of speculation. Shorting a stock also can be used as a hedge. The goal here is to offset the losses of your long position. In a traditional stock purchase, the most you can lose is the amount you paid for the shares, but the upside potential is theoretically limitless. Short-sellers receive all kinds of criticism. They've been accused of hurting businesses, manipulating public opinion and spreading rumors about a company or stock.
It's even been implied that short-sellers are almost unpatriotic for not supporting publicly traded companies.
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