How Does Shorting a Stock Work: The Risks and Benefits of Short-Selling a Stock
Have you heard of the term ‘shorting a stock’ but don’t know what it means? Short-selling is an opportunity for investors of all types to sell shares that they don’t actually own.
If an investor thinks that a share is about to drop, then it’s an opportunity to get a high-return quickly. The flipside is that there is a high risk of capital loss, making it a real gamble. That’s why, though the terminology may be common, most people haven’t actually been involved in it.
Despite the risk, however, many investors still practice short-selling. How does shorting a stock work? If you want to know more about this practice and if it’s right for you, keep reading.
How Does Shorting a Stock Work
Since short-sellers are working with stocks they don’t actually own, they use a broker to acquire them. The broker buys the stocks then lends them to the short-seller, crediting them with the proceeds. The short-seller sells the stock with the intent to buy them back at a lower price.
The broker has a few reasons to get involved. First of all, they receive a fee for the initial transaction. They also get any dividends paid out on that stock. Finally, the short-seller promises to buy back the stock as a return on the loan.
The risk for the seller is that the broker can call back that loan at any time. If the stock hasn’t dropped in price, or, worse, if it’s increased, the seller is responsible for covering all the costs.
Why Short-Sell Stocks
Seems like a high degree of risk, right? But what happens if the stock price plummets considerably? The seller can buy the stocks back at a much lower rate, generating a quick profit. And all this without having had to put money out upfront.
In a bear market, when optimism is low, shorting is a way to still be able to turn a profit. For that reason, many hedge funds will practice this as a way to provide a return on investment to their clients.
The Greater Risk of Short-Selling
When a large number of investors and hedge fund managers think a market dip is imminent, they can actually worsen the results through shorting. The effect it can have on businesses can be devastating. Many experts believe the short-sellers are responsible for the collapse of investment bank Bear Stearns.
Is Short-Selling Stocks Right For You
If you want to get involved in short-selling, there are a few questions to ask yourself. How does shorting a stock work is just the first.
How much can you afford to lose? You really need to be prepared for the possibility of loss, so it’s essential that you recognize your limits and don’t exceed them.
Otherwise, as long as you have a good understanding of the market, it’s a great opportunity at generating profits. Choose your targets and study their marketing reports. If you get the strong sense that a companies shares are due for a downturn, you’ve found an opportunity.
Shorting isn’t for everyone, but with some market literacy and a strong sense of self-control, the rewards can be significant. If you would like to know more about the process of getting a stock loan, let us know. We make it easy to get approved quickly.