Short selling is a term often used in stock trading. Therefore, investors must understand the meaning of short sales well. Shares are the property of a company, which the investor buys through a broker to make a profit. At times, the investor expects the value of the stock to rise and makes a deal to win in the long run.
A short sale is a practice of selling securities that the investor did not have at the time of sale. The investor expects the stock price to decline in the future, and sells it at a low price to buy the security at a lower price. The short seller “lends” the securities to be sold and redeems them to be returned to the creditor. If the stock price falls, the investor can make huge profits by selling them short.
Conversely, if the price increases, the investor may lose a large amount of money.
An investor sells short positions for two main reasons: opportunism and portfolio protection. Sometimes an investor may feel that a particular stock is costly and doomed to fall. Short selling allows you to profit from this price drop. Besides, it helps investors isolate their stocks during an economic downturn when all stock prices should fall.
Some investors also see this as a way to diversify a long portfolio by selling short stocks. This can reduce portfolio volatility as a result of the economic downturn and help make a profit even when stock prices fall.
Nevertheless, short sales are associated with many risks, since the mechanism here is much more complicated than a regular transaction in the stock market. There is a significant risk associated with the possibility of making large profits.
Risks of Short Selling Stock
Although there is an excellent opportunity to make money in a bear market with short sales, there are also significant risks before starting a short trade. Here are a few of them:
- Unlimited loss potential. When you have a large stock, you can lose a maximum of 100% (if the stock reaches $ 0). But, by shortening the share, the price can grow indefinitely so that it can support an unlimited amount of money.
- It’s hard to find enough stock to cover a short sale (so increase your losses if you are moving in the wrong direction).
- You are required to pay dividends declared at the time you reduced the shares.
- The price is subject to increased volatility when many people try to hedge their short positions at the same time (in terms of Wall Street, this is called a small squeeze).
With high leverage comes great responsibility.
Selling shorts is considered a position using borrowed funds, as well as buying a share using borrowed funds. Many of the same risks apply, although short selling has a few more risks, it is also a significant weapon in your investment arsenal. With short sales, you can profit during lows and buy long-term in bull markets. Profits in the downward and upward markets should significantly increase your chances of profitability in the markets if you know the risks and take appropriate security measures to protect yourself.