How to use a Short Selling Strategy
So far we have discussed your options to make money when the stock market is going up. But what happens when we enter a bear market, or when there is sudden panic in the markets. There is a way to make money as the market or a stock falls, it is called short selling.
Simple short selling
Example: Michael believes that a WXY company’s stock is going to decrease in value, it’s sales and income are shrinking and it is currently overpriced with a P/E ratio of 80. Michael could set up a short trade. Michael enters the short trade at $50 per share for 100 shares earning him $5,000.
His broker lends him the shares (from their reserves or from another investor) and credits his account with the proceeds. Over the next 4 weeks the stock falls by $10 per share or 20%.
This means 100 shares of the company now cost $4,000. At some point Michael needs to close the position by buying back the same number of shares (called covering) to realize his actual profit. Now seems like a good time. He buys the shares for $4,000 to give back to the lender of the shares, this closes the trade. Michael realizes a profit of $1,000 on the trade.
So even though the stock value went down Michael profited.
However, if the stock price had continued to rise by 20%, Michael would have had to close the trade at $6,000, which would have meant he would have suffered a loss of $1,000 or 20%.
Short selling as hedging
Hedging refers to the act of limiting your risks by making a trade that moves in the opposite direction to which you expect your stock to go. So if the stock moves against you’re the other investment will decrease or limit your risk.
Example: Mary owns 100 shares of Google Inc at $500 per share worth $50,000. She has already made a huge profit on the stock, but she fears the stock will have a temporary fall, due to a bad earnings report. She decides to short her own stock. Mary opens short trade for 100 shares of Google Inc at $500 per share.
She is credited the amount of $50,000 to her account by the broker, but she does not need to borrow the stock because she already owns it.
Mary now has $100,000 in her account. The stock moves down 10% to $450 per share. Mary closes the trade by purchasing the stock. Mary made $5,000 on the trade, 10% of $50,000. Her investment pot is now still worth $50,000. She has $45,000 worth of Google stock and $5,000 cash. This means, even though the stock she owned decreased in value, the amount of capital she has remained the same.
Mary could then invest this $5,000 in 5 more shares of Google, meaning she now has 105 shares worth $50,000.
Shorting is a good way to hedge against the risk of your stock decreasing in value.
It is also a good way to make money as the stock market falls.
Shorting can be difficult for some people to understand.
No upside risk limitation. If you short 1,000 stocks at $1, and the stock actually catapults up to $3, you would have been credited $1,000 but when you close out the short you would have to pay $3,000. This would be a huge loss. Losing your entire investment and adding extra loss of 2 times your investment.
High – only advanced investors should try this.