I believe it will make it much easier for you to visualize how it works, what the dangers are, and why someone might be tempted to engage in it despite the very real potential for throwing them into bankruptcy if they aren't careful as it can expose the owner to theoretically unlimited losses. You believe the stock price of ABC is grossly overvalued and is going to crash sometime soon. You are so convinced of this, you decide you want to borrow those 10 shares and sell them with the hope that you can later repurchase them at a lower price, returning them to me, and pocketing the difference.
You approach my stock broker. You tell the stock broker you will borrow the shares from my account, replacing them someday along with any dividends I should have received. The broker says, "Alright, I'll let you borrow Joshua's shares", takes them out of my account without me knowing - it never shows up on my account statement and I never have any other notification that it has been done - and lets you borrow them.
Institutional investors actually get paid for lending out their securities, which is one of the reasons some major financial institutions enjoy the practice.
They lend their stocks in exchange for certain collateral and increase the income they would otherwise enjoy. As a side note: In this alternate universe, this isn't a good deal for me. If you don't repay the shares, my brokerage firm will have to reimburse me for it but they could go bankrupt in a market meltdown, causing me to rely on the SIPC program to learn more about this, read What Happens If My Broker Goes Bankrupt?
If my account balance exceeds the SIPC limit , I could lose a lot of my money because the stock that was supposed to be parked in my account wasn't really there. Not only that, even if everything works out fine, while you have borrowed my stock, any dividend replacements you pay me aren't entitled to the super-low dividend tax rates but, rather, are taxed as ordinary income, which can be almost double the tax rate.
Of course, there is an easy way to stop this from happening and that is to open a cash account instead of a margin account. If the stock goes up, you lose money because you are going to have to pay a higher price to repurchase the shares and return them to my account. The fact that you have to replace any dividends I would have been owed is one of the reasons short sellers aren't particularly font on shorting high dividend yield stocks.
Combined with the fact that high dividend yields attract buyers interested in passive income and you understand why the concept of yield support is such an important one for certain types of firms. On the other hand, if the company goes bankrupt , the stock will be delisted and you can buy it back for next to nothing - a few pennies per share, most likely - pocketing almost all of the earlier sales proceeds as profit.
When you short a stock, you are exposing yourself to a lot of potential financial pain. In some cases, when investors and traders see that a stock has a large short interest a big percentage of its float has been shorted by speculators , they will attempt to drive up the price to force the shorts to "cover", or buy back the shares before it gets too out of hand.
It is important to remember a few things if you are thinking about shorting stock. First, never assume you will be able to repurchase a stock you have shorted whenever you want at a price that resembles ordinary experience. The liquidity has to be there. If there are no sellers in the market, or there are so many buyers including panic buying, which is caused by other short sellers attempting to close out their position as they lose more and more money , you have a serious problem.
The most famous, and catastrophic, example of this is the Northern Pacific Corner of You may or may not have the opportunity to buy or sell on the way up or down, prices may instantaneously reset, the bid or ask jumping.
It is something that is obvious to experience investors but new investors take for granted. Even in regular stock investments that do not involve shorting stock, there is this mistaken idea that a stop loss order can protect you under all circumstances, which simply isn't true.
The major risk as it pertains to shorting stock is a corporate buyout or merger. Finally, shorting stock is subject to its own set of rules. If you are going to short stock, think about limiting your potential losses by purchasing an out-of-the-money call option. Sure, it will cost you money and potentially cut into any gains you would have made but it might be the difference between a painful, buy survivable, disaster and a catastrophe that destroys your family's finances for years.
Let's look at an example. Right now, on March 19th, , any fundamental investor or quantitative analyst can tell you the shares of Netflix are disgustingly, offensively overvalued.
They trade at a price-to-earnings ratio of more than Even Netflix's management has expressed astonishment that investors are so foolish to pay a price this detached from reality. Imagine if you wanted to short it. To keep it simple , we'll say you want to short shares and we'll ignore the small commissions you would otherwise owe. However, your call option would be worth a fortune. True, you still lost money shorting stock but as far as insurance policies go, it was a cheap one.
In many situations, buying a put option, which gives you the right, but not obligation, to sell stock at a predetermined price is the more intelligent way to gamble on a company's shares collapsing. That type of trade involves its own unique risks but it can be far more compelling than shorting stock under the right circumstances because you can limit your total losses whereas your losses are theoretically unlimited when you short stock.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal. Updated February 18, Buying a Put Option Is Often a More Intelligent Way To Gamble Than Shorting Stock In many situations, buying a put option, which gives you the right, but not obligation, to sell stock at a predetermined price is the more intelligent way to gamble on a company's shares collapsing.More...