… or Shorting Stocks For Dummies (Because they don’t have a book out for it yet)
If you’re a beginner investing in the stock market and trading stocks, there’s probably many terms and phrases that you’re not familiar with. One of the many terms that you’ve heard by now is “shorting stocks”. The idea behind it is that an investor expects a company’s stock to go down in value and he/she will invest in it accordingly.
Typically when you buy shares of a company, you buy at a low price and then sell it at a higher price than what you paid. In shorting a stock you “borrow the share from a broker and sell them at a certain price and at a later time, you buy those those shares at a lower price to return to the broker. Of course, there is more to it that just this simple explanation of the process.
1. Risk – There is more risk involved in shorting a stock then there is in buying a stock to go up (long) in value. If you borrow a stock while it’s trading at $20 and it runs up to $100, then you’re out $80 a share. Unlike when you “go long”, you can only lose $20 a share as it falls to $0.
2. Locating A Stock – In the past year there has been a law passed that prevents someone from borrowing stock if you can not locate any available shares. In recent years, a trader would borrow shares that no one had and wait for the price to drop to buy the covering shares, but how can he buy them if no one had any? In this case it was referred to “naked shorts”.
3. Outstanding Short Position – The number of shares of a company held short, it is measured in absolute numbers, and/or a percentage of the float of the stock. Usually if the position is more than 10%-20% of a company’s total shares, it means that the bad news has already been factored into the stock’s price. If you find a company with a large short position, you need to avoid it all together.
4. – Margin Account – To be allowed to short stocks you will need to open what is referred to as a margin account. A margin account is where the funds will come from for you to borrow the stock. Take into consideration that you will be charged from your broker a “broker loan rate” (fee) based on the price of the stock. Also you will not get any interest on the margin account or have it rolled over into a money market account on the funds not being used.
5. Liquidity – Just like I said about an outstanding short position, if a company has too many share outstanding (liquidity) you need to avoid the stock. A stock that is not highly liquid should not be shorted. In this case you may find yourself stuck in the stock where you may not be able quickly liquidate your position.
In a future post, I’ll discuss more stock shorting tips for you.
Here is part two of 10 Things To Know About Shorting Stocks.
To our readers who invest in the stock market, what’s your advice for beginners who want to to learn how to short stocks?
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