Taking a short position means you are effectively selling that security. Short sales with respect to the stock market refer to the process whereby you borrow shares of a company's common stock and sell them immediately. You do this when you expect the company's stock to decrease in value. When the stock price declines, you purchase the shares at the lower price and return them to the entity that initially lent you the shares, typically your brokerage firm.
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Developing a Strategy
There are numerous strategies that incorporate short selling stock. The simplest strategy is the previously described plain vanilla short sale. Perform a detailed analysis before leaping in, because if the shares rise after you've sold them, you can potentially record substantial losses. A company's stock price can decline for many reasons. If the overall market declines, most companies' stock prices decline also. Quarterly and annual earnings releases are a good time to plan your short sale. If you expect a company's earnings to be lower than the market consensus, shorting the stock may be appropriate.
Execute the Transaction
You are prohibited from publicly making statements in an effort to try to drive the stock price down so that you can profit from this. It is viewed as market manipulation, which seems like an issue for the largest investors. However, since discussion boards dealing with investing have proliferated, even small investors are subject to scrutiny by regulators. As far as the actual trades, prepare in advance so that your account options give you the ability to make short sales. Sometimes this requires maintaining a minimum balance, and often involves borrowing on margin. Also, exchange-traded funds provide you with a low-cost option for shorting indexes. ETFs are traded on exchanges just like stocks, making them an attractive option for novice short sellers.
Monitor the Transaction
Timing is very important, because you need to close out of the short sale while it is showing a paper gain. If you borrowed 100 shares and sold them at a price of $10 per share, the initial proceeds are $1,000. If the shares decline to a value of $5 per share, you can purchase the 100 shares for $500 and return them to the lender. This would earn you a net profit of $500, not including broker's fees. Set your parameters at the onset of the trade. This will be based on your risk tolerance and expectations for the range of the stock price's movements.
Protect with "Borrow"
Some public company stocks have relatively lower amounts of daily trading volume. When you decide to close out the short sale, you can record substantial losses if you can not obtain enough shares on the open market to repay your lender. To reduce the risk of this taking place, enter into an agreement with a brokerage firm to obtain what is referred to as "borrow." For a small fee, the brokerage company will provide you with access to a reserve of the specified shares. It is like a form of insurance against the chance of the company's stock's trading volume being too low.