Shorting Stock (My Final Episode)
Doug in Boston asks how to short a stock. Find out what shorting is, what the risks are, and how to do it.
Elizabeth Carlassare
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Shorting Stock (My Final Episode)
Today’s episode is my last episode of Money Girl’s Quick and Dirty Tips for a Richer Life. I want to thank you all for listening and for all your enthusiasm, encouragement, e-mails, and comments – they’ve really meant a lot to me! I hope that you’ve found the episodes entertaining and educational. They’ll continue to stay posted for listening! And there will be new episodes ahead from another host for the podcast.
And now on to today’s topic.
Doug in Boston called in with this question:
“Hello, Money Girl. This is Doug in Boston. I’ve been a long time listener and I’m trying to figure out shorting stocks. I heard a lot when Bear Stearns crashed about how people made out big who shorted Bear Stearns just before it crashed. I understand the basic premise that when you short a stock you’re betting that a stock is going down and that’s how you make money. But how does it work? How do you actually short a stock? Alright. That’s all. Thanks Money Girl.”
And thanks for that question, Doug.
How Shorting Works
You’re right that when you short a stock, you’re betting that that price is going to fall. The concept of shorting a stock is a little counter-intuitive because you actually sell before you buy. You borrow shares of a stock you don’t own and then sell them. The proceeds from the sale appear in your account. If your hunch is right and the price falls, you can then buy the shares back at a lower price.
Here’s an example of how shorting works. Let’s say you think the share price of Darjeeling Dumpling company is going to plummet, so you sell short 100 shares at $10 a share. Your brokerage credits $1,000 to your account. You get lucky and Darjeeling Dumpling’s stock price goes down to $7 a share, so you buy those 100 shares back at a cost of $700. Your profit is $300, the $1,000 credited to your account from selling the stock short minus your $700 cost of buying back the shares.
Speculating Versus Investing
A word of warning! Shorting a stock is more like gambling than investing. It’s risky because your losses can be bigger than the amount you invest. Normally, when you invest in the stock of a company, your loss is limited to your investment amount. With shorting, however, if your instincts prove wrong and a stock you short goes up, instead of down, you can lose more money than you invest.
To continue the example, imagine instead what would happen if your hunch about Darjeeling Dumpling was wrong. The stock climbs up to $20 a share at which point you decide that you just can’t take it anymore and you’ve got to get out of the transaction. You buy back the 100 shares you sold short at $10 a share at the price of $20. Ouch! Your loss is $1,000: the $1,000 initially credited to your account from the short sale minus the $2,000 cost of buying back the shares. In this case, you would have to add $1,000 to your account out of your pocket to close out the short position.
Limiting Your Losses
If you do short a stock, it’s smart to limit your loss by setting what’s called a “buy stop” at the price beyond which the loss is more than you’re willing to stomach. It’s reasonable to set a “buy stop” price that’s, say, in the ballpark of 5 to 20% above the price at which you sold the stock short.
Before you can short a stock, you need to have a margin account, which is a brokerage account that lets you buy stocks with borrowed money. Be sure to check with your broker about your account’s initial and ongoing margin requirements. You’ll need to keep sufficient cash in the account. You’ll also need to pay interest on the money you borrow from the brokerage to short stocks.
Shorting Isn’t for Everyone
Shorting stocks isn’t for most investors. If you don’t want to watch your positions closely, shorting stocks definitely isn’t for you. Shorting stocks is speculating, not investing. Remember, there’s a risk that you could lose more money than you put in. You’ll need to buy back the shares you shorted within a certain amount of time whether they’ve gone up or down, so that you can give them back to the lender.
If you do decide to short a stock, here are a few tips:
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Limit your short positions to a very small portion of your portfolio. Only risk “play money” that you can afford to lose.
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Limit your loss by setting a reasonable “buy stop.”
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And lastly, once you’ve shorted a stock, watch it closely.
So here’s hoping that your hunches are right. And remember, keep the bulk of your nest egg in solid, long-term assets and investments that will help you grow your wealth for the future.
It’s come time for me to focus on new projects, so, as I mentioned earlier, today’s Money Girl episode is my final one. Thanks again to you, my listeners, and to Grammar Girl and the whole QuickAndDirtyTips gang. It’s been great to be part of this podcasting adventure. If you’d like to get in touch with me in the future, you can reach me at theoriginalmoneygirl@gmail.comcreate new email. That’s theoriginalmoneygirl@gmail.comcreate new email. You can also find me on Facebook under my real name, Elizabeth Carlassare.
Cha-ching! That’s all for now, courtesy of Money Girl, your guide to a richer life.
As always, everyone’s situation is different, so be sure to consult a tax or financial advisor before making important financial decisions. This podcast is for educational purposes only and is not intended to be a substitute for seeking personalized, professional advice.
Thanks for listening!
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