Stocks: The Risks of Short Selling
We can't emphasize how risky shorting is, well,
it's very, very risky.
- History has shown that stocks in general have an upward
movement and over the
long run most stocks appreciate in price. You are betting against overall
direction of the stock market, which isn't a good idea.
- The potential loss on the short sale of stock is unlimited.
This is because a stock can (theoretically at least) rise infinitely. On the other hand, a stock can't go below 0, so your upside is
limited. This means that you can lose more than you initially
invest, but the best you can earn is a 100% gain if a company goes out of
business.
- Shorting stocks involves using borrowed money,
otherwise known as margin trading. Just as when you go long on margin, it's
easy for losses to get out of hand because you must meet the minimum
maintenance requirement of 25%. If your account slips below this you'll be
subject to a margin call. Then you’re forced to put in more cash or liquidate
your position at a loss.
- If a stock starts to rise and a large number of short
sellers try to cover their positions at the same time, it can quickly drive up
the price even further. This phenomenon is known as a short squeeze. Usually, news in the
market will trigger a short squeeze, but sometimes traders who notice a large
number of shorts in a stock will attempt to induce one. This is the reason it's
advisable to not short a stock with high short interest. A short squeeze is an
excellent way to lose a lot of money extremely fast.
- The final and largest complication is being right too
soon. Even though a company is overvalued, it could conceivably take awhile to
come back down. In the meantime you are vulnerable to interest, margin calls,
and being called away. Academics and traders alike have tried for years to
come up with explanations as to why a stock's market price varies from its
intrinsic value.
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Are
there restrictions on selling short?
Shorting is subject to
many restrictions on the size, price, and types of stocks you are
able to short. For example, you can't short sell penny stocks and
most short sales need to be done in round lots.
In addition, the SEC, NYSE, and NASD have rules preventing short
selling unless the last trade of the stock is at the same or
higher price (known as an uptick or zero plus tick).
These rules exist so that
investors can't sell short in a declining market. Continuous short
selling on a falling stock will keep forcing it down, damaging the
market further.
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Two main reason to short:
To speculate -
The most obvious reason to short is to profit from an overpriced stock or
market.
Probably the most famous example of this was when George Soros risked $10 billion
in 1992 that the British pound would
fall and he was right. The following night Soros made $1 billion from the trade,
his profit eventually reached almost $2 billion.
Very few sophisticated money managers short as an active investing strategy like
Soros.
To hedge - Hedging is an investment technique designed to offset, or
neutralize, a potential loss on one investment by purchasing a second investment
that you expect to perform in the opposite way. For example, you might sell
short one stock, expecting its price to drop. At the same time, you might buy a
call option on the same stock as insurance against a large increase in value. The majority of investors use shorts to
hedge. This means that they are protecting other long positions with offsetting
short positions.
Next==>>
What is
margin trading?
Ordinary riches can be stolen; real riches cannot.
In your soul are infinitely
precious things that cannot be taken from you.
-- Oscar Wilde, The Soul of Man
under Socialism, 1891 --
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