Using Securities Lending for Shorting Stocks: What You Need To Know
On April 7th, 2016 Tony Sagami told the readers of his popular Rational Bear investing newsletter to short the stock of growing furniture empire Conn’s. The retailer’s furniture was flying off the shelves, and investors were happy with the rapid growth.
So why would Sagami tell his readers to short a seemingly successful company? Shorting stocks is all about spotting weaknesses while other investors are blindly riding out a jump in price. Let’s start with a look at how stock loans work…
How a Stock Loan Works
Shorting a stock sounds like a complicated financial tool Wall Street bankers use to get rich. But it’s a simple process.
A broker finds an investor willing to loan their shares in a company in return for interest paid on the stocks borrowed. The broker then gives them to a short seller to sell to a buyer at the current market value.
When the price (hopefully) falls, the short seller buys the stock back in order to return what they borrowed. The difference between the high and low price goes to the short seller.
Stock Loan Definition
A stock loan, also called securities lending, works just like a regular loan. Most of the stocks owned by individual investors are purchased in the name of the brokerage firm. So the brokerage can afford to loan out some of that stock like a bank would the extra money they don’t need in their reserves.
Stock lending has a big advantage over buying a stock outright. Buying stocks with loans from brokers gives an investor the power of leverage. Leverage is when you borrow more stocks than you have the cash to buy. Leverage lets you buy 50, 100, or sometimes 200+ times what you would have been able to buy with your available cash.
The catch is leverage can also magnify your losses. And that’s not the only downside of shorting. Because the lowest a stock can go is 0, your gains are limited. But if a stock decides to go up, it can keep going, making your potential losses unlimited.
There are many things to consider regarding the risks and benefits of shorting stocks. But now you know enough to get started on the right foot. The more you learn, the more you’ll find that shorting stocks for a profit has risks just as big as the rewards. But with the right plan, you can get the odds working in your favor.
“So, When Is Shorting Stocks Smart for Me?”
Just two months after Tony Sagami recommended shorting furniture retailer and lender Conn’s, the stock tanked. Investors that took his advice banked a 21% profit.
Shorting stock can be a very lucrative investment strategy. But before you start planning on opening your own hedge fund, you need to consider all the risks that come with the process.
This past summer, short sellers betting on Tesla’s downfall were left with a $2 billion dollar paper loss after the stock made a sharp 16% jump. Shorting stocks for more than you can afford to lose can wipe out your entire portfolio.
Research the financials of the stock you want to short. Don’t invest more than you can afford to lose. Shorting is a powerful investment strategy so start small and don’t let fear keep you from learning. Find out how to get your first stock loan now.