The Long and Short of Stocks
You may have heard that the behavior of the stocks and the stock market is a cycle. There is a bull market when the stock prices are going up whereas there is a bear market when the stock prices are going down. But did you know that you can earn profits even when your stocks are not going up? In fact, many have made a fortune during bear markets, when the stock prices are going down! How can that happen? Let me introduce you to the concept of going short and its advantages and disadvantages. You can then decide if you still want to go short or just continue with the more traditional investment strategies.
Profit in Going Short
You own a stock when you ‘long’ it, but what happens when you ‘short’ a stock? It is said that you go short when you buy and sell stocks that are not your own to earn profit. Yup, you read it right. You use stocks that are not your own and still earn money from it. Sounds illegal? Not really. It has been stock market practice that an investor borrows stocks from a stockbroker and sells these stocks. The investor then buys the stocks back at a lower price to earn money. For example, you expect that Google stock prices will go down in the next six months. You also know that your friend John has 100 shares of Google stocks and you also know that the current stock price of Google stock is $420 each. You then borrow the 100 Google stocks and sell them for $420 each. After six months your prediction comes true and Google stock prices go down to $400 each. You then buy back the 100 shares at $400 each. You return the same 100 shares to your friend John and earned for yourself $2,000, even when the stock prices are going down. You sold the stocks at a high price and bought them back at a lower price. This is why those that go short are termed bearish.
Loss in Going Short
Of course, not everything always goes as you plan. What if the price of the stocks you borrowed didn’t go down after you sold them? What if they went up instead? What if the selling price of the stock sky-rocketed to three times the price you sold it for? Obviously, those that went short would be losing more money. This is not uncommon in the stock market where stocks that are expected to go down exceed everyone’s expectations and recover. Let’s take the earlier example. Assuming you already sold the Google stocks at $420 each. Instead of the stock price going down after six months, the stock price went up to $440 per share. In order to gain back the 100 shares of Google stocks, you have to put out $44,000, a $2,000 loss on your side. This is only assuming that the stock prices only rose by $20. But what if it rose to $500 per share or even $520 per share, you stand to lose $10,000.
This is why going short is very risky and the possible investor may lose more than he bargained for. At least, when you go long, you risk losing only what you invested in buying those stocks. In going short, you risk losing an undetermined amount of money. This is why beginners in stock trading are advised not to go short. There is still hope of profit in the bear market; I suppose the question is, are you willing to risk it?