The stock market can be a scary place and not just for beginners.
Here’s a scenario. You are an experienced trader. You have done careful research on ZYX and feel confident in its fundamentals. As well, all your favorite indicators line up on the charts so you take the plunge. You buy 2000 shares at $5.03.
Next morning you wake up and ZYX is trading at $3.50. Your brow starts to sweat. The hairs on your arms stand straight up. You feel like you have been punched in the gut. You check the news. Turns out the CEO was caught in bed with his secretary and the stock opened at a limit down.
I know it doesn’t help, but take my word for it, you are not alone. You have a lot of company. There isn’t a single trader who has not gone through the weak knees, the gasping for breath moment when everything in front of their eyes goes a little fuzzy. Unfortunately, being a trader, it all comes with the terrain.
What I try to do in my blog posts is chaperon you through some of those SEEs (significant emotional events). I have found over the years, the best way to do that is with information. I get a lot of questions about trading. However, the single most asked query, one that transcends all genders, all age groups, the one issue with the most mystery and that has the most confusion swirling all around it is short selling.
What is Selling Short?
Short selling allows you to make money when a stock falls and, to most, this sounds instinctively wrong. There are some who think this even has echoes of illegal (like most people I know). But short selling is 100% legal and can be very lucrative. With that said, I believe the best way to shed a light on short selling is an example.
Let’s say you bought a candy apple red 1965 Mustang convertible, with red/white interior and a white ragtop. Regrettably, though, you could not pick it up right away so your brother offered to go get it for you since brothers do these sorts of things – don’t they?
Now, much to your dismay your brother decided to sell your mint 1965 Mustang convertible on the way home for $16,000. You find out and needless to say, you are extremely distraught – as you should be. You may want to pound on your brother but, heh, he’s your brother.
In order to resolve this thorny situation, your brother needs to replace the car he “borrowed” meaning he is SHORT one mint 1965 candy apple red Mustang.
So your brother has two options. If he wants to stay your brother and not go to jail, he has to buy another 1965 Mustang to replace the one he just sold. If he finds one and can purchase it for $14,000, he would walk away with a smooth $2000 profit, however, if he could only find one at $18,000, he would end up losing $2000.
We just “borrow” stocks from a broker
In the stock market, it’s the exact same concept. You borrow shares of XYZ Company — just like the Mustang. At some point, you have to return those shares. If you can buy them back for less than you sold them for, you make a profit. If not, you take a loss.
The only difference is that the venue for both buying and selling the stocks would be the stock market. You borrow shares from, or via, your brokerage, not your brother.
Short selling is frequently vilified and viewed as ruthless operators out to destroy companies. Liquidity is provided to the markets via short selling provides liquidity to the markets. It also prevents stocks from being bid up to ridiculously high levels on hype and over-optimism. Although abusive short-selling practices such as bear raids and rumor-mongering to drive a stock lower are illegal, short selling when done properly can be quite lucrative.
The small print
When account holders initiate a short position, their broker must borrow the shares on their behalf in order to satisfy its settlement obligation with the clearinghouse.
The agreement through which these shares are borrowed requires that your broker provide the lender with a cash deposit in an amount equal to or greater than the value of the loaned securities as loan collateral. The lender charges a fee for providing this service, generally expressed as the difference between the interest which accrues to the lender on the cash deposit and the agreed upon rate of interest which is rebated back to the borrowing broker (typically pegged to the Fed Funds overnight rate for USD denominated cash deposits).
We’re the Plan in “Plan your Trade and Trade your Plan” – TraderJanie
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