Friday, August 9, 2013

Shorting Stocks

When you buy a stock it is called going long which is what most people are familiar with, buying and holding stocks for the long run.  There is another side to trading stocks and it is called short selling or going short.  Most investors that are starting out seem to have a hard time understanding the concept or may not feel comfortable shorting a stock.  When you go long or buy a stock you anticipate that it will go up in value and that at some point you will be able to sell it and make some money.  When you short a stock you anticipate that the stock will drop in value.  You enter the position by selling, in other words you borrow the stock from the broker since you do not own the stock and then buy to cover to close your position.

Let's look at this trade I did below back when (GE) was trading at $16.55.  I entered a limit order to short 1000 shares (9:37am) of the stock at $16.55.  At this point I did not own those shares so my broker let me borrow them.  Since I was correct and the price dropped I went ahead and bought the shares back by entering a buy to cover limit order for 1000 shares at $16.40 (9:42 am).  This was a $150 profit in 5 minutes ($16,550 - $16,400 = $150) you make money by selling at a higher price and buying back at a lower price.  It's like borrowing your friend's printer that costs $100 and selling it to your neighbor for the same price.  You then buy that same model printer back for $90 and give it back to your friend to make a $10 profit.

On the other hand if the stock rises it can get ugly.  Technically the stock could go to the moon or at least very high and the longer you let it rise without closing the position, the more money you can lose. Let's say that GE had risen to $20.55 instead, I would've lost $4,000 plus interest based on the amount of days I kept the stock with a margin account.  Most of the time you may hold the short position for as long as you want. There are times when a broker may force you to close your position.  If during the time you shorted the stock there were dividends payed out, you will have to pay them back to the lender.  Shorting stock is another good tool to add to your trading but before you do so make sure you understand the risks involved in the art of short selling.

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