When it comes to trading stocks, most people
have heard the old maxim about buying low
and selling high.
When you sell short, the sequence is reversed:
You identify a stock that you think will decline,
and borrow it from your brokerage. Then you
sell it with the expectation of buying it
back after it falls and returning the shares
to your broker. Your profit is the difference
between the price at which you first sold
the stock, and what you later bought it back
for.
To sell short you have to have a margin account
with your brokerage firm. That’s an account
that lets you borrow stocks using your own
eligible securities as collateral. Selling
the borrowed stock, or “selling short,”
leaves a negative share balance in your account
called a “short position.” When you buy
it back, you’re closing out that position.
Let’s walk through an example. On March
7, this stock starts trending lower, breaking
through the support level of 97 dollars on
March 9th. As the stock continues to fall,
you could take out a short position, borrowing
100 shares and selling them at around 84 dollars
a share for a total of $8400. While it’s
unclear how far any pullback could go, placing
a stop order just above the high of the last
day would help a trader mitigate their risk
if this were to rally. The trader has an opportunity
to buy at a lower price as long as yesterday’s
high isn’t violated.
In this case, the stock continues to trend
downward. You could then buy back those borrowed
shares, say when the stock hits 76 dollars,
for $7600. That’s a profit of $800 on your
short sale.
The most obvious risk of short selling is
that the stock you expected to decline, rises
instead. That would force you to buy it back
at a higher price than you sold it for. And
because there’s no limit on how high a price
could rise, your potential loss is unlimited.
One way to attempt to control such risks would
be to use a buy-stop order to limit the damage
to the trade in the event of a large upward
move. There are many methods for determining
where to place your stop order. Some traders
might place the buy stop just above a moving
average, or above the most recent high price
the stock achieved. This would represent a
possible change in the behavior of the price
action and the short seller might want to
move on quickly. Remember though that there
is no guarantee that a stop order will be
executed at or even near your stop price.
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