You follow the process described in the previous section and initiate a short position. That money will be credited to your account in the same manner as any other stock sale, but you'll also have a debt obligation to repay the borrowed shares at some time in the future. That represents your profit -- again, minus any transaction costs that your broker charged you in conjunction with the sale and purchase of the shares.
Keep in mind that the example in the previous section is what happens if the stock does what you think it will -- declines. The biggest risk involved with short selling is that if the stock price rises dramatically, you might have difficulty covering the losses involved. Theoretically, shorting can produce unlimited losses -- after all, there's not an upper limit to how high a stock's price can climb.
Your broker won't require you to have an unlimited supply of cash to offset potential losses, but if you lose too much money, your broker can invoke a margin call -- forcing you to close your short position by buying back the shares at what could prove to be the worst possible time.
In addition, short sellers sometimes have to deal with another situation that forces them to close their positions unexpectedly. If a stock is a popular target of short sellers, it can be hard to locate shares to borrow. If the shareholder who lends the stock to the short seller wants those shares back, you'll have to cover the short -- your broker will force you to repurchase the shares before you want to. Short selling can be a lucrative way to profit if a stock drops in value, but it comes with big risk and should be attempted only by experienced investors.
And even then, it should be used sparingly and only after a careful assessment of the risks involved. 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: Short selling can be risky, but also lucrative. Nothing is inherently wrong with short selling, which is permissible under the regulations of the Securities and Exchange Commission SEC.
However, the 'short and distort' type of short-seller uses misinformation and a bear market to manipulate stocks. Short selling is the practice of selling borrowed stock in the hope that the stock price will soon fall, allowing the short seller to buy it back for a profit.
The SEC has made it a legal activity for several good reasons. Short seller's often engage in extensive, legitimate due diligence to uncover facts that support their suspicion that the target company is overvalued. Finally, short selling also provides investors who own the stock have long positions with the ability to generate extra income by lending their shares to the shorts.
This is the inverse of the 'pump and dump' tactic, whereby an investor buys stocks takes a long position and issues false information that causes the target stock's price to increase. Generally, it is easier to manipulate stocks to go down in a bear market and up in a bull market. The 'pump and dump' is perhaps better known than the 'short and distort,' partially due to the inherent bullish bias built into most stock markets, and because of the media's reporting of the extended U.
The theory is that frightening the stock's investors will cause them to flee en masse , thereby causing a decline in the stock's price. The thrust of their message is to convince investors that regulatory authorities have serious concerns about the company and that they are contacting the stock's investors as a gesture of goodwill.
Any individual or entity that attempts to contradict their claims becomes the target of their attacks. In other words, the market manipulator will do everything in his or her power to keep the truth from coming out and keep the targeted stock's price heading down. Movies like Wall Street and Boiler Room brought these types of stock market manipulations to the fore and helped educate investors on the risks of playing the markets.
When a 'short and distort' maneuver succeeds, investors who initially bought stock at higher prices sell at low prices because of their mistaken belief that the stock's worth will decrease substantially.
During the chaos that enveloped some prominent bankruptcies , such as Enron in or Nortel in , investors were more susceptible to this type of manipulation in other stocks than they would have otherwise been. As a result, many innocent, legitimate, and growing companies are at risk of getting burned, taking investors along with them.
Here are some tips for avoiding being burned by a 'short and distort' scheme:. The best way to protect yourself is to do your own research. Many stocks with great potential are ignored by Wall Street. By doing your own homework, you should feel much more secure in your decisions. Ask yourself these questions to spot the key characteristics of a good research report :.
The SEC requires that everyone providing investment information or advice fully disclose the nature of the relationship between the information provider the research analyst and the company that is the subject of the report. If there is no disclaimer, investors should disregard the report. Investors can get good information from pieces published by investor relations firms, brokerage houses, and independent research companies.
Using all of these sources will provide information and perspectives that can help you make better-investing decisions. Ideally, your view is correct, and when the price has dropped, you buy shares at that lower cost to pay back the ones you borrowed. However, if the price goes up, at some point you still would need to finish the transaction — that is, you'd have to buy that stock to repay the brokerage. When a stock is heavily shorted, and investors are buying shares — which pushes the price up — short sellers start buying to cover their position and minimize losses as the price keeps rising.
This can create a "short squeeze": Short sellers keep having to buy the stock, pushing the price up even higher and higher. This is what happened with the shorted stocks targeted by the Reddit investing crowd. Generally speaking, you can only engage in short-selling using a margin account. This essentially is a loan from your brokerage, which will charge you interest and require you to maintain a certain level of funds in that account.
When the value drops below that threshold, your brokerage will require you to replenish the account. The process is pretty simple. An investor borrows shares of stock, sells them, and then buys the shares back. Hopefully at a lower price. This strategy is used for speculation and hedging. It is based on a belief or prediction that the price of the stock is headed downwards. Sounds simple enough. But, the reality is that things do not always go as planned.
Betting on a drop in the price of a stock is a risky strategy that is not often successful. Especially compared to holding on to shares for the long-term. But, does shorting a stock make it go down? The answer to this question is a bit more complicated than you might think.
Interested in learning more about how stocks can create wealth? Imagine you think a stock is overvalued. Your prediction is that because of the overvaluation, the price is likely to drop.
Your strategy here, when short selling, would be to borrow a certain number of such shares from your broker and then sell those shares on the open market. You can buy the stock back at that price and return them to the broker. What if the price does not go down? There is a limit on profit, however. To summarize, shorting a stock is the sale of shares that the seller does not own.
Most of the time, these shares are borrowed from a broker. If the price of the stock falls, the shares can be bought back for less than they were sold for.
The short seller will make a profit. If the stock price rises, the stock will have to be bought back for more than it was sold for. The short seller will incur a loss. Dividend stocks have risks too.
Want to know what they are? As you might have sensed, short-selling comes with a significant amount of risk. When buying a stock, an investor can lose the entire amount they invested. For that to happen, things would have to go really bad. With short sales, an investor can lose an infinite amount of money because the price of the stock might keep rising indefinitely.
In the worst-case scenario, investors might end up owing money to their brokerage. Huge risks, however, can result in great profits, when things go as speculated.
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