Table of Contents
Chapter 1: Introduction to Short Selling Stocks
Chapter 2: Short Selling Terminology
Chapter 3: Short Selling Limitations and Risks
Chapter 4: Who Should Get Involved in Short Selling
Chapter 5: Factors to Consider before Short Selling
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Chapter 5: Factors to Consider before Short Selling
– Costs Involved
– Skills Needed
Chapter 5: Factors to Consider before Short Selling
There are many factors to consider in detail before you start short selling. Costs involved and the skills needed are the most important.
An estimate of the costs you will incur will tell you how much you will need to gain to make a profit from the trade. There are many costs that apply on a short selling transaction. Some of these are evident and have to be paid upfront while others are not. Let’s take a look at some of the costs that a short seller can incur in his transaction.
The broker will charge the short seller a commission for the sale and purchase of shares.
The SEC lists certain stocks as ‘hard to borrow’. If a short seller wishes to short on these stocks, he may additionally need to pay his broker a special ‘hard to borrow’ fee. The broker is not legally required to intimate the short seller about this fee and he can simply debit the margin account of the borrower for this fee. This fee is usually charged daily and it can lead to a substantial cost for the investor.
As discussed earlier, the borrower is obligated to pay all earnings like dividends on the borrowed shares. The dividend payment is fairly predictable but bonus shares and splits are not known in advance. The short seller can not factor such potential costs into his investment strategy.
A novice investor can conduct some traditional stock investment strategies with varying degrees of success. These investments, which count on a rise in stock prices, are fairly straightforward. This is because ‘long’ investing is based on the intuitive concept of profits being related to an increase in the price of an asset.
In short selling, the investor has to base his decisions on a lot of indicators, especially because his risk is unlimited. A decline in a share price may be limited to only one company in which case a thorough understanding of the company and its business is needed. He will need a thorough knowledge of the products of the company whose stock he has shorted and have a clear idea of what can influence its stock price.
The short seller should also have a good understanding of what makes the markets and individual stocks rise or fall. This involves understanding how a panic situation can quickly unfold in the market. A good sense of timing is also critical for successful short selling. Above all, a short seller must have a reasonable expectation from the investment and avoid giving in to the temptation for windfall gains.
You also need to be adaptable and make quick decisions as the market situation changes. When short selling, you need to have a Plan B in place if things go wrong.
Short selling is a risky investment practice which is even considered unethical by many. However, these transactions often keep the stock market balanced, especially when they are being inflated far beyond their intrinsic value. The trading volume in the stock market and liquidity are also kept at high levels by short sellers. Understanding how short selling works and what the risks are can help you become a successful short seller.
