As strange as it may seem, it is possible to make money as the price of a stock goes down, if you’re willing to accept the risks.
How To Profit In A Falling Market: One popular strategy used by traders to profit as prices decline is selling-short. This process is defined as borrowing a security and selling it on the open market. You then cover the position by purchasing it later at a lower price, pocketing the difference after repaying the initial loan.
Confusing, right? Look at it this way — Company X is trading at $50 per share, a trader borrows 100 shares and sells them for $5,000. Company X stock suddenly declines to $40 a share, at which point the trader purchases 100 shares to replace those borrowed, netting $1,000.
Alternatively, if Company X stock rose to $60 per share and the trader decided to close the short position before incurring any further losses, the loss would equal $1,000 ($10 per share loss times 100 shares) plus any dividends, commissions, and interest.
Because the trader is borrowing shares from a brokerage firm, they must first establish a margin account to hold eligible bonds, cash, mutual funds, and/or stocks as collateral. As with other forms of borrowing, the trader will be charged interest on the value of the outstanding shares until they're returned.
Also Read: 6 US ETFs With Significant Ukraine Exposure
For the uninitiated, a “margin account” is a type of brokerage account in which the broker-dealer lends the trader cash, using the account as collateral, to purchase securities. A margin account holder can borrow up to 50% of the equity in their trading account for the purchase of new securities or for short sales on normally traded stocks.
Understanding The Risks
Potentially Limitless Losses: When a standard trade is placed, the downside is limited to 100% of the money invested. However, when shorting a stock, its price can keep rising, meaning that theoretically the amount a trader would have to pay to replace the borrowed shares is limitless.
Margin Calls: If the value of the collateral in the margin account drops below the minimum equity requirement, usually 30% to 35% of the value of the borrowed shares, depending on the firm and the particular securities owned, the brokerage may require the trader to deposit more cash or securities to cover the shortfall immediately.
The process of shorting a stock is relatively simple, yet it is not a strategy for inexperienced traders. Only knowledgeable, practiced investors who know the potential implications should consider shorting.
