There are numerous ways to invest in the stock market and begin building the foundations of a robust, profitable stock portfolio. One unusual, risky way to profit off a company’s bad decisions is by shorting a stock. Shorting a stock is borrowing money to invest in shares in a corporation at a lower price than what it normally trades for, then selling them at an even lower price. Despite the potential to generate a huge return on an investment by shorting a stock, there is also a comparable risk of losing it, so learn how it works before doing it blindly. This article explains what is shorting a stock, as well as its advantages and disadvantages.
The Concept of Shorting a Stock
The simplest answer to the question “what is shorting a stock” is that it simply means that you borrow an undervalued stock, then sell it back for less than it is actually worth, and make a profit off the deal in the process. If this sounds more complicated and contradictory of the whole idea of investing in the stock market in the first place, then perhaps it helps to understand that it is as almost as old as the market itself.
The first man to ever short a stock was a 17th century Dutch trader named Isaac Le Maire, who bought shares of the Dutch East India Company anticipating competition would drive its price down further. That competition never materialized, Dutch regulators banned the practice, the shares went up, and Le Maire left Amsterdam a broken man after he got caught lying to artificially drive the stock’s price down.
In the United States today, the process is technically legal as long as it follows rules and regulations set in place by the Securities and Exchange Commission. The actual process of short-selling involves going to a broker and making a payment for a specific number of shares. After receiving the money, the broker borrows the shares from other sources, and then sells these shares in order to pay for the ones you wanted to own in the first place. As long as the shares stay below the purchase cost, the deal is still profitable.
Advantages and Disadvantages of Shorting a Stock
As complicated as it is to understand what is shorting a stock at first, it is equally important to understand the advantages and disadvantages of doing so. Doing it wrong could not only be financially catastrophic, but illegal as well. It is as important to follow the law while making a deal as it is to avoid losing money. Operating in violation of SEC rules and regulations is a felony. In 2010, the SEC passed restrictions to keep short selling from driving down the price of a stock more than 10 percent in a single trading day.
Advantages of Shorting a Stock
- It enables investors to buy stocks at a lower price, which can make it possible to buy a greater volume of stocks for the same amount of money that it would take to buy stocks at their trading value. Despite the increased risk, this can make it attractive to a beginning investor who is still trying to understand what is shorting a stock.
- Since the initial investment for the same amount of stocks is not as great, there is a potential for such a deal to lead to even larger profits than buying the same amount of stocks at cost.
- With enough of an investment, short selling can make it possible not only to profit off of a company’s poor management decisions, but thrive off of them.
- Very few companies make money during an economic downturn, and short selling can be one of the only ways to profit off a bear market.
- It is good for a healthy stock portfolio to fill it with a mix of both long options and short ones. The best way to find stocks that may prove to be good candidates for short selling is to see which ones financial analysts are telling you not to buy.
Disadvantages of Shorting a Stock
- Except in the case of crashes, the overall trend of the market is to go up. Since short selling is, in essence, betting on who will lose, it is still possible to lose money on a trade if the company gets its act together and the stock actually goes up. If this happens, you will be forced to pay a margin call with the money from your dividends.
- Money borrowed to pay for the sale must inevitably be paid back at some point whether or not the deal is a profitable one. If you cannot pay for it out of dividends your other stocks have earned, then you could end up losing a lot of money. Some reckless investors managed to lose everything they owned by trying to short sell companies whose prices went up.
- As if that were not enough, the risk of running afoul of regulators when making a mistake is far from inconsequential. In addition to the aforementioned rule on shorting a stock by more than 10% a day, not declaring a short sale in the first place is also a violation of Securities and Exchange Commission rules and regulations.
- Not all brokerages offer short sales. Hedge funds are more likely to engage in short selling because they already have other stocks they can sell to cover the short sales.
- If enough investors get together and short sell a stock, they can drive a company to the point of bankruptcy. That was one of the factors behind the Crash of 2008.
Understanding what is shorting a stock can prove overwhelming at first, but it is necessary to know how something works before doing it. When it involves such a sizable initial investment with comparable potential for both high profits and crippling losses, then it becomes even more necessary.
Short selling is the sort of thing that makes investing the stock market so exciting, so complicated, so alluring, yet so dangerous at the same time. Do it right, and you have the potential to reap the rewards of corporate incompetence. Do it wrong, and you could end up with nothing. If you did not know what is shorting a stock before, then hopefully now you do.
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