What exactly is shorting?
If you’re new to investing or trading the stock market, I would STAY FAR AWAY FROM SHORTING. However, the more comfortable you get with trading and the more profitable you become, I believe it’s a must have in your trading repertoire. Essentially, shorting involves borrowing x amount of shares from your broker and selling it at a specified price (set by you) on the open market. At some point, you buy back the securities on the open market and return them to your broker. Thus, allowing you to bank mucho dollars!
Security “ANL” is trading at $10 per share. It is in your opinion that this stock sucks and will eventually collapse leaving shareholders in the poor house. You borrow 1000 shares from your broker and sell them for $10 per share on the open market. Your account will now be credited +10,000 for the short sale. 1000 x $10 = $10,000.
Tomorrow you wake up to a news briefing that states the finances for ANL are under SEC investigation. Shareholders react negatively to this news and the price of the stock plummet to $2 per share.
You set an order to buy 1000 shares of "ANL" stock at $2 per share and return the shares back to your broker. The transaction costs you $2000.
You have now profited $8000 on that short sale. How?
Well remember, your account was credited $10,000 after you sold short 1000 shares at $10 per share (open market sale) . You bought the shares back on the open market for $2 per share, at a total cost of $2,000 (open market buy). $10,000 (initial purchase credit)-$2,000 (cost from repurchase) = $8,000.
As odd as it seems, your broker isn’t concerned with the monetary value of the shares, they just want the shares back at some point. You have successfully shorted ANL and you’re 8k richer. Easy? Maybe. Maybe not!!
Let's look at it from a different perspective.
Let’s stick with “ANL” securities. However, instead of waking up to an SEC investigation. You wake up to breaking news that Google intends on paying top dollar for the company. OUCH! You check your news feed and realize that the stock is now trading for $18 per share. Do the math and you’ll realize that those borrowed shares now cost you an extra 8k. $18 per share x 1000 (amount of shares owed to your broker) = 18k (total cost of transaction to repurchase)..
As you can see, shorting can be a great way to make money but it takes a good knowledge of the markets, combined with excellent risk management skills.
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