Why beginners should not try shorting a stock

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Why beginners should not try shorting a stock

There’s a lot of potential cash to be made in the world of stocks and shares, and especially for those who specialize in shorting stock. The idea of making big profits in a short time, without having to put in hours of hard manual work or actually do anything physical at all, the thrill of the pursuit and the win, the rewards for pitting your brain against the system and coming out on top, and then you get to do it all over again.

Stock shorting specialists play a key (and totally legal) role in the market, particularly by helping to stop stock prices being overinflated, and yes, it definitely seems like a glamorous world – one where huge rewards await those willing to take a few chances, and in many ways that is true, but shorting stock has an edge. It can leave you broken, cost you many thousands, and generally become your worst nightmare. That’s an unlikely outcome for an experienced short seller – although even the top performing people in this sector are always aware of and prepared for that possibility.

However appealing it sounds to those with little experience of the stock market, shorting stock is not something beginners should try, and here we look at the major reasons why we believe this is so.

Let’s start by looking at what shorting a stock involves, as running through the process helps to highlight the amount of hidden work, and risk, involved in what seems at first glance to be an almost casual way to make huge amounts of cash.

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What does shorting a stock look like?

1. The first thing you need to do is open an account with a broker. It must be what is called a ‘margin account’, and if you already have an account you can easily arrange to have the margin agreement added to that.  (A margin account is needed because it allows your broker to buy stocks on your behalf, using their cash.) Brokers are bound by law to ask some searching questions about your financial assets before they agree to authorise this. Basically, they want to know you are solvent and have assets as shorting stock can be a risky financial manoeuvre.

2. You do lots of research, looking for information which suggests particular stocks may be about to lose value, and then before they do you instruct your broker to borrow some on your behalf.  Let’s say you borrow 1000 shares costing $10 each for $10,000, sell them immediately for $10,000, and put that cash into your exclusive margin account. (Obviously, you shouldn’t even think about using this money for anything other than this short stock transaction.)

3. If you have calculated things well the value of each stock shares and you then buy them back at a lower price, before handing them back to the dealer you borrowed from originally. So, let’s say your $10 stocks cost $5 when you bought them back you have spent $5,000 of the $10,000 made on the investment.  After broker fees you will have quite a tidy profit indeed.

Read:- 17 Startup Investment Due Diligence Checklist

Where’s the catch?

There’s a saying that if something looks, sounds, or seems too good to be true it probably is – so is this the case with shorting stocks?

The short answer is no, but it is something which takes a lot of research, skill, nerve, patience and a safety pot of cash in reserve. Those who are new to the world of stocks and shares will find it very difficult to successfully short stocks until they have gained that in-depth understanding of how the entire sector works. Shorting a Stock is something you can learn to do, but it definitely needs commitment and time to gain experience. It’s definitely not a get-rich-quick scheme, and there’s plenty that can trip inexperienced people up.

Things which can go a problem when shorting a stock

1. The shares you buy may buck the trend and recover, or even gain value. You still have to buy them back, even if they cost you more than you sold them for – leading to an automatic loss.

2. Brokers fees and interest rates can be extremely high.

3. If the shares pay dividends while you hold them this must be passed back to the person whose shares you ‘borrowed’ initially. If for some reason the dividend was lost during the buy/sell process you are personally responsible for finding that cash and paying it over.

4. The potential for loss is unlimited. While value can only drop as far as zero there really is no ceiling for how high they can rise, and don’t fool yourself – they can swerve the trend and gain value despite every indicator being that they shouldn’t even be able to. Here the key factor which separates the newcomers from the accomplished short stockers is knowing when to cut those losses. If the price rises just a little it could easily be tempting to hold on and hope things turn downwards again, only to find the opposite happens and you end up out of pocket by many thousands. There’s no place for pride in the arena of short selling, so a clear ceiling for each deal must be in place from the start.

Other things beginners need to know

The market is not rational. It’s possible that your hours of research spent identifying an excellent possibility doesn’t pan out simply because the market doesn’t deem those particular factors as a financial threat or risk.

Some brokers are the type who will take action if a particular stock shorting scheme starts to go awry, but you should never rely on that. It’s vital that you closely monitor all of the short stocks you are dealing with, pretty much constantly.

Shorting stock isn’t something you can just wander into and make a fortune, but with the right attitude, effort, homework and patience it’s certainly possible to get skilled enough to make it work.