During bear markets, some investors are able to make money when individual stocks decline thanks to an investment strategy called “short selling.” But what exactly is this strategy and how can investors use it to profit?
Traders normally invest in a company because they hope its share price will go up. Investors who take a “short position” hope for the opposite — they are betting that the company’s share price will go down.
Shorting is a high-risk strategy as it involves using borrowed money to trade stocks or other assets that could increase in price. Here’s a brief overview of how shorting a stock works and how investors can profit from doing so.
How to short a stock
The process of taking a short position in a stock is simple. The first step is to open what is known as a margin account with a broker. This type of account allows investors to borrow up to double the account’s cash balance from their broker.
Once this account is set up, the investor can then borrow shares from their broker. The shares are sold in the open market, and if their price declines, the investor then buys the same amount of shares in the open market and returns them to the broker, making a profit.
However, if the shares increase in price, the investor will owe that money to the brokerage firm. Sooner or later, the investor must “close” the short position by buying back the same number of shares and returning them to the broker.
Most of the time, investors can hold a short for as long as they want. That said, holding a short position for a longer period of time will mean higher costs, as brokers charge interest when investors borrow shares from them.
Short selling step by step
As outlined above, investors will profit if the share price of the company they are shorting declines over time. Here’s a step-by-step example of how that works:
- Let’s say an investor identifies a company trading at $100 per share that they want to short sell for 100 shares.
- They will have to open a margin account with their brokerage firm for $10,000 (100 x $100) that will, for example, charge them 8 percent interest for six months.
- After six months, the company’s share price declines and is trading at $75.
- The investor purchases 100 shares at market price for a total of $7,500 and returns them to the broker.
- The investor profits: $10,000 (short sale proceeds) – $7,500 (short position) – $800 (margin interest due) = $1,700 (profit).
Investopedia notes that because of its many risks, short selling should only be done by disciplined traders who are familiar with the risks and the regulations involved. That said, it can be a potent strategy for speculation or hedging during bear markets.
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Securities Disclosure: I, Priscila Barrera, hold no direct investment interest in any company mentioned in this article.