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What Is "Shorting" Stocks?

Sep 17, 2008
In the context of a stage play, shorting stocks involve these three acts: the borrowing, the selling, and the returning. It will have three main characters Company, Shareholder, and Investor. The story opens with Company selling his stocks to Shareholder one day. Stocks are units of ownership; purchasing more stocks means bigger ownership of Company. Interested, Shareholder buys most of them ten stocks, to be exact at thirty dollars each. Shareholder now owns 50 percent of Company.

All is well until Company falls sick, and the value of his stocks is in danger of falling. Investor, who has been closely watching how Company is doing, thinks that it is only a matter of time when Company folds up. Shareholder, on the other hand, starts to worry about Company, since he owns half of it with the stocks he bought.

But for Investor, it was an opportunity to make some money. He approaches Shareholder, and offers a proposition. I can borrow the stocks for a while, if you want says Investor.

While Shareholder is anxious about Companys condition, he still doesn't want to let go of his stocks. Okay, on one condition. You must return them to me at the price I bought them, Shareholder responds. Investor goes out and finds other investors who still hope that by some divine miracle, Company will get back in shape. Always diligent in his endeavors, Investor ends up selling all his borrowed stocks for thirty dollars each. He then takes the sale proceeds and opens up his own enterprise. There is no rush in returning the stocks to Shareholder; he only agreed to return them at its original value at some point.

After some time, Company undergoes another crisis and the value of his stocks went down to fifteen dollars each. It was just as Investor expected, so he buys back the borrowed stocks, for a lower unit price of ten dollars. He returns all ten of them to Shareholder as agreed.

But what if Company recuperates? Investor, then, would have to purchase the borrowed stocks at a much higher price. Such is the risk of shorting stocks. The extent of loss on the part of the trader is another uncertainty that adds to the speculative nature of this kind of investment. It thrives on a down market, which is something positive for those who are savvy day traders, who are watching the market 24/7, since its direction is crucial to shorting stocks. They must know when the market rises or falls, and at which rate.

Engaging in this kind of trading has the potential of incurring big losses, since investors are usually not allowed to short position penny stocks. Traders in short position are also liable for the dividends that stocks earn when the market is bullish.

It takes accurate forecast and good if not impeccable market timing to thrive. Shorting stocks has a high level of uncertainty; notwithstanding, the market activity is also subject to a game of perception (sometimes, deception) that is shaped by various factors, such as politics, media, and the oligarchs of the industry. While it promises tempting returns, an individual investor should think twice in shorting stocks.
About the Author
Justin DeMerchant is the founder of stock watch pro, best stock trading , and stock trading basics where information on stocks and investing can be found.
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