Here are the other five things to know when shorting stocks.

6. Margin Calls – This is probably the scariest thing about owning a short position in any company.If the stock you’ve decided to short moves in the wrong way (stock price rises), your broker will insist that you do one of two things. One, deposit more money into your account, enough to cover the purchase price of the stock at the current price. The other choice is that your broker will insist that you sell some of your long positions to cover the margin call or they will do it for you in their own way.

7. Early Sale – If the original owner of the shares that you borrowed decides to that they want to sell the stock, you must replace it — either by finding other shares through your broker or buying it on the open market. Remember all you did originally was “borrow” the shares.

8. Short Squeeze – If you’re new to the stock market then this is a term that you might not be familiar with. It’s a term that is used quite often on Wall Street. A short squeeze is when the price of the stock jumps up in value quickly, causing short traders to “cover” their positions. Which means that they have to buy shares to cover the ones that they borrowed. This typically causes higher prices, which prompts more people to sell and to take profits. This is something that you may never want to get caught in the middle of because of the ferocity of the situation as well as get quite expensive.

9. Properly Covering You Position – You may not even realize it, but you can have a short and a long position at the same time. When you go to “cover” your short position, you need to tell your broker clearly that the shares you’re buying are to cover your short position. If you just buy the share while still having a short position, you’ll have conflicting positions. Many times people are in a rush to cover their position, that they may not even realize their mistake of overlooking their selection, especially online traders.

10. Dividends And Taxes – If you have borrowed and shorted a dividend-paying stock, you will receive the dividends, but you, in turn, must pay the original owner the value of those dividends. Also, should you hold a short position for more than one year, well, tough luck — the IRS still treats capital gains as short-term gains. Ah, Uncle Sam is always reliable!

I hope these ten things I’ve given to you will help you in your trading. If you are new to the stock market, then it’s wise to stay away from shorting stocks until you learned more of the basics.

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… 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?

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Chasing a stock is a common mistake you need to be aware of, or your portfolio will take a beaten. This is when a stock had some good news come out and you missed the information when it was first released. In other words, the stock price made some good gains and you didn’t take advantage of the situation. I’ve seen stocks jump in value by over 30% and watch other traders try to guess at if the price would come back down temporarily so they could jump in. As the price goes up, they try to stay near the low end of the trading range, hoping for the pull-back. When the pull-back does come, it comes in the from of profit-taking from other trader and investors that got in on the initial news.

This can also take place over a period of a couple of days where the stock price jumps as much as 100% or better, only to have it come back down to levels of the original price before the move up.

Just because the stock price has moved up in a relative short period, doesn’t mean you should jump in for a quick gain. The traders that do that are very experienced in investing and this practice should be left for them to do. Any stock that you are planning to get into should be one that you’ve researched. You should be very familiar with it’s balance sheets, as well as other financial information in regards to the company. If not, take some time to check out a stock market site for information. You can never do enough research.

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1. Stock or Equities

Stocks and equities are basically the same thing. They’re securities that represent owning a piece of a company. There are also equity mutual funds, which are also in the same class. There are several ways to acquire stocks and/or equities. You can purchase shares of a company through Initial Public Offers (IPO’s). You can buy from a broker and/or brokerage house (i.e. TD Ameritrade). Also, if your company offers a 410K plan, you can buy stocks through their program. What good about owning equities is that they are easily liquidated if you need to raise capitol right away. Their performance is quite volatile and generally give the best returns over the long haul. With the way equities move in value over the short term, in most cases they’re not ideal for short term investing unless you are very active on a daily basis.

2. Fixed Income Securities or Debt Instruments

Securities that will generate return within a period of time fall in this class. Bonds are the most common of them all. Returns are in the form of dividend income and/or interest. Bonds are issued by either the government, a company that want to raise capital to increase their business or a bank fixed deposit. It’s basically a loan to them from you. They can be purchased through corporate bonds, bank fixed deposits or debt mutual funds. They are considered a safer mode of investing since they aren’t as volatile as equities. It is also used by investors to protect their stock portfolio. The yield varies depending on the economic conditions at the time of issuance.

3. Real Estate

I don’t think I really need to explain what real estate is, but to cover all bases, ownership of land, homes, or commercial property are considered real estate. Real estate is sold in the open market by buying land, houses or commercial property, as well as taking ownership through inheritance.
Another way to invest in real estate is through funds that only involve real estate properties. They are known as REIT (Real Estate Investment Trusts). Investing in real estate can bring great rewards. Look at any wealthy person and you will see that they’re investing in real estate. To own rental properties will bring high yield over the long term while the tenant’s rent will (in most cases) cover the mortgage and other monthly expenses.

4. Gold

Again I don’t think there’s any need to explain what gold is other than it is the most sought after precious metal in the world. There was a time that the American dollar was related to gold, referred to as the gold standard. Gold can be purchased through jewelers as well as banks. Once can also invest in gold through gold ETF’s (Exchange Traded Funds) and mutual funds. The benefit of investing in gold is that it has always held it’s value against inflation. It’s not effected by the fluctuations in either the stock market or any currency. Many of the smart investors hold a position in gold to help hedge against the volatility in the markets. Gold will bring high returns over the long period of time.

5. Commodities

Commodities consist of of any type of tangible item that can be bought or sold. Precious metals, base metals, ferrous metals, agricultural products are just some of the many things that are considered a commodity. To invest in these you would need to go through a commodity exchange, such as NYMEX (New York Mercantile Exchange) and the CME (Chicago Mercantile Exchange) to name a few. I don’t recommend a beginner investing in commodities. The risks are very high and unless you have advanced knowledge in this area, I say stick with the equities (stocks) that handle these products.

To properly make it in the stock market, you should have a well balanced portfolio. I suggest that you learn more about each one before investing any of your hard earned cash in the markets. It will help you to seek the advice of a professional before doing any of the things that were discussed here in this post. General questions are always welcomed and I will do my best to answer and help.

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