You may have heard that it’s possible to make money no matter which way the market is moving. This statement comes as a surprise to many people because, on the surface, it appears as though there’s no way to make a profitable investment other than buying an asset or security that rises in price over time.
But by knowing how to short a stock, it’s also possible to profit from the losses of a company’s share value.
Over the long-term, global stock markets have, in general, trended upwards. Most investors choose to invest in ways that allow them to profit from this upward momentum. But when you stumble upon a scenario that demonstrates to you a stock will likely be headed downwards, a strategy referred to as short selling can allow you to make money in a down market.
Short selling involves selling a stock that you don’t own or have acquired on a loan from a stockbroker. Other types of securities, such as options, can also be short sold.
Read on to learn how to short a stock.
How To Short A Stock Using Options
One method of shorting a stock involves using an options-based strategy. Creating what’s referred to as a synthetic short position, it’s possible to sell a call option while also buying a put option with the same expiration date at the same strike price.
If the stock decreases in value, the put option will rise in value. If the stock goes up in price, however, the value of the put option will fall while the sold call option will rise. This will result in a loss on the total trade. You will have to repay that loss just like you would in a traditional short sale.
Short selling with options is a little different than a traditional short sale. For example, the use of options involves a specific time for the short position, because options come with an expiration date, also known as an “expiry” time. At this predetermined time, the option will be forced to execute its trade. When the expiry time comes due, you have to close out the position or repay the debt you owe because of the options contracts.
For this reason, options are generally used by seasoned, short-term traders. If you have a long-term investing strategy that includes a stock that you perceive as being likely to drop in price, you may not be interested in learning how to short a stock using options. The added flexibility of using a traditional short sale may be beneficial to you in that case.
How To Short A Stock Using A Traditional Short Sale
In a traditional short sale, someone who already owns the stock will lend you shares in exchange for your commitment to return those shares to them at a later date. You then sell the borrowed shares and pocket the profit that remains.
The goal of shorting a stock is to sell at a lower price than you borrowed. You’re trying to profit by repurchasing your borrowed shares at a lower price. For example, say you borrowed shares and sold them at $50 per share. The price then drops to $40, and you repurchase the shares at this price. The difference of $10 per share becomes your profit.
But there’s a caveat. In the event that the share price of the stock you borrowed rises, you stand to lose a potentially unlimited amount of money. This is one of the least understood aspects of how to short a stock.
How To Short A Stock While Avoiding Potential Pitfalls
There’s one caveat to shorting a stock – you could potentially lose more than you risked in the first place. For example, if you short stock in company XYZ at $50, and the price rises to $150, you’re now on the hook for the $100 difference when you originally bought the stock at just $50. So, you’ve lost twice as much as you risked.
And given that there’s no real limit to how high a stock can go, there’s also no limit to how much you can lose on a short position. Many amateur investors have learned this lesson the hard way. Of course, taking a big loss is one way to learn how to short a stock!
The simplest way to manage this risk is to either avoid shorting stocks or only short stocks that are certain to go down. Of course, those options probably aren’t appealing or realistic to you if you’re interested in learning how to short a stock. Unless you have insider knowledge, it’s difficult to know for sure if a company’s shares are destined for a downward spiral.
How to Short a Stock And Know It’s A Good Decision
Shorting stock is definitely riskier than just owning the same stock. The reasons are twofold. First, you can lose more than you invested in the first place, creating a metaphorical black hole for your money to disappear into. Second, shorting a stock is somewhat more complicated than buying and holding a stock.
You have to not only know how to execute the trade in the manner of your choosing, but you have to accurately predict that a stock’s price will fall in the near term.
It’s a lot harder to predict a short-term event that it is to predict a long-term event. In general, most companies that stay afloat see their share prices rise over time. That’s why the stock market as a whole tends to rise when being examined from a decades-long perspective.
Companies and their stocks come and go, but the ones that contribute a valuable product or service to society keep growing and returning value to their shareholders. Word eventually gets around, other investors pile in, and so long as the company remains under decent management, things continue moving forward.
That’s why most investors choose to buy and hold a stock for the long-term. It’s also why traditional retirement funds like 401(k)s typically involve stocks in part or in whole, and why large companies tend to offer stock options to their employees as bonuses or severance packages.
If you invest in something like an index fund that follows the overall market performance of, say, the NASDAQ exchange, your odds of cashing out at a higher value 30 years from now are pretty good.
But shorting a stock is a different can of worms entirely. Unless you really know what you’re doing, it’s more difficult to profit and much easier to lose. Many investors have fooled themselves into thinking they’re some kind of hot-shot trader who can make a quick buck by knowing how to short a stock.
However, if you do have reliable knowledge that a company’s share price is about to take a hit, then knowing how to short a stock provides an additional way to make money in the stock market.
How To Short A Stock Summarized
In summary, there are two primary ways to short a stock. First, you can use options. Options execute themselves within a certain time frame, assuming they are not closed out manually by the investor. Options are often used by more seasoned stock traders.
The more common method of shorting a stock is referred to as a traditional short sale. When you borrow shares of a stock and later buy them back at a lower price, you have succeeded in shorting a stock.
One way or another, shorting a stock involves profiting from a stock’s decrease in value. The most necessary component of knowing how to short a stock is knowing with reasonable certainty that a company’s share price is going to fall very soon.
In the event that you try to short a stock and wind up being wrong, you stand to suffer major losses if the share price rises. Because there’s no real limit to how high share prices can go, there’s no real limit to how much you can lose, either. Something to keep in mind when you’re learning how to short a stock.