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10 Things To Know About Shorting Stocks: Pt.1

… 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.

Reader Question:
To our readers who invest in the stock market, what’s your advice for beginners who want to to learn how to short stocks?

© 2011 Beginner Investing

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19 Responses to “10 Things To Know About Shorting Stocks: Pt.1”

  1. Mohammad Ramnauth says:

    We should emphasize, however, that investing isn’t a get-rich-quick scheme. Taking control of your personal finances will take work, and, yes, there will be a learning curve. But the rewards will far outweigh the required effort. Contrary to popular belief, you don’t have to let banks, bosses or investment professionals push your money in directions that you don’t understand. After all, no one is in a better position than you are to know what is best for you and your money. *-;*

    Till next time

  2. Jimmy says:

    Wow, very informative article! I did read somewhere that going with covered calls is a less risky option because you make a small commission up front. Something to look into!
    Jimmy´s last post Make Funny Wedding Save The Date Photo Magnets And Invitations For Summer, Fall, Winter, Or Your Beach DestinationMy Profile

  3. Cy says:

    Shorting stocks is definitely more risky than “going long.” Before anyone even attempts to short a stock it’s definitely a good idea to make sure they know the basics of the stock market and are fully aware of the risks.

  4. Ionut Popa says:

    Maybe you can do another article about FOREX. I’ve heard it’s easier for beginners when it comes to investing.
    Ionut Popa´s last post Downtown Toronto at nightMy Profile

  5. Vic says:

    In spite of your excellent advice, anything to do with stocks is a little too scary for me. Maybe I’ll feel less skittish when (and if) the market stabilizes.

    Good job explaining shorting stocks though. Smile

  6. Beth Parker says:

    It sounds like shorting stocks is something you should avoid if you’re new to investing. Maybe it would be better to start with something a little less risky.
    Beth Parker´s last post “Before” Pictures of Our New House—and a Progress UpdateMy Profile

  7. algodude says:

    Thanks for a coherent piece on a subject many beginners find a bit daunting. Shorting is certainly not for the feint of heart, but it can be a useful tool for traders that have done their homework. Nice job!
    algodude´s last post Beware Black Swans Sporting Fat TailsMy Profile

  8. alex chris says:

    both part 1 and part 2 of the guide are excellent. I am a newbie in the investment world and Joanne I find all your articles easy to understand and useful.

    Thanks a lot

  9. Very interesting and written clearly!

  10. Jeanette says:

    Thank you for this informative article on shorting stocks. Makes me think maybe I could do it.
    Jeanette´s last post Tangled by Leslie Early, Video by Kirk FisherMy Profile

  11. Very informative! Thank you for sharing!
    Chris Lewis ? (@Wireless_Geek)´s last post Job Motivational Quote – 2011.11.5My Profile

  12. zeenath says:

    Self discipline is very important in trading stocks. You have to fix a target and sell or buy at that price, otherwise you may miss your goodluck. While shorting shares its always better and safer to short sell the shares you already hold. When the price zooms, sell it and wait for it to decline after a certain level and buy it again.

  13. Surya says:

    Stock market is a risk management. First we want to get advice from a practical person on investing the stocks. If, you are given some dollars to start out in virtual cash which you use to build up your very own stock portfolio. You can buy and sell stock (with your fantasy dollars) at the real prices of the stocks as they go up and down during the day. We must be feel confident on trading stocks without any fear.

  14. Jake says:

    I have two tips. The first is almost universal in my trading philosophy and particularly for new investors and even more particularly when shorting: no your exit point. You should have a goal in mind which targets your profit and limits your risk. I like 8% as a loss range, because it is enough that you feel it but not so much you feel committed to staying on for the ride. It’s also important to know what profits you are looking for, so that you take them. A profit on paper is, well, worthless. Don’t be too greedy as a stock is declining. If you’ve made 10 to 25 percent, consider gradually reducing your position so that when the stock bottoms and rebounds, you are mostly out of it.

  15. Amrit Sukhani says:

    Risk management is the most essential factor to be taken into consideration while shorting stocks. One should not short stocks that are not present in his portfolio; otherwise, he will have to square off the deal irrespective of the fact whether the price of the stock has shot up after his short-selling. However, it is best to short stocks carrying some kind of adverse news along with them prior to the opening of the markets. Margin money has to be maintained in the account.

  16. Daisy says:

    Well when I first got into shorting stocks, I started by investing with smaller amounts. Only after I felt more confident, I began investing larger amounts into the stocks. Short stocking can actually fetch you some good profits, if you trade sensibly. I think the five steps posted by you, are really simple and effective to follow. Look forward to more articles and tips from you in the future. Nice work.

  17. Hanan says:

    This is pretty interesting. I never knew anything about stocks actually. This was a very informative article to read about. This article gives great advice!

  18. svesten says:

    The risk management is one of most important things you should know in trading stocks. Your knowledge could save you loses and help you earn huge profit.
    Thanks for the article , it is useful !

  19. Brent says:

    Shorting stocks is a simple concept that a lot of people get confused with. I think you did a great job in explaining the basics of shorting stocks. The key point you outlined above is the unlimited risk factor that is involved with shorting.

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