Best Choice For Beginners!
Free Trading Education!
Free Demo Account!
Big Sign-up Bonus!
Perfect For Experienced Traders!
Shorting a Stock: How to Do It + Understand the Risks
Did you know it’s possible to profit from stocks when they go down in price?
Shorting a stock — or short selling — is a trading technique that can help you find opportunities to trade stocks when prices are trending downward.
It might sound strange, but it’s actually very common — and yes, it’s perfectly legal.
In fact, this type of trading inspired the movie “The Big Short.” Of course, that movie is a pretty extreme example. As a new trader, you won’t (and shouldn’t) be taking massive short positions.
But it’s worth your time to learn about short selling because it can expand your ability to find trades in different market conditions.
Before you start shorting, it’s super important to learn the basics — and get familiar with the patterns that can help you spot a good short.
What is short selling? How is it different from going long a stock? How can you use this technique? Let’s go over all of that and more.
Table of Contents
What Does Shorting a Stock Mean?
Short selling is where you’re betting against a stock. You believe that the price will go down, so you go through a process of borrowing shares to sell and buy back at a lower price, netting the price difference in profit.
Short selling pretty much turns the traditional “buy low, sell high” trading model on its head.
How Does Shorting a Stock Work?
The idea of short selling might sound weird at first, so let’s break down how it actually works.
1. Borrow Shares
First, decide how many shares you want to short, then set out to find shares to borrow.
Best Choice For Beginners!
Free Trading Education!
Free Demo Account!
Big Sign-up Bonus!
Perfect For Experienced Traders!
You’ll have to borrow these from a broker, but be warned: not all brokers offer short selling, and even among those who do, you can’t always find shares to short. That’s why I made this “No Borrow No Cry” video.
2. Sell the Shares
Once you borrow those shares, you sell them. Yep! You’re selling shares that are on loan … but (spoiler!) you gotta return them later.
Ideally, you want to sell the shares at a high. For example, it might be a stock that’s currently pumped up price-wise, but without any good reason.
In an ideal world and if the trade goes the way you want, the stock price will start to plummet after you sell them.
3. Buy the Shares Back
Once the price (hopefully) declines, it’s time to buy back those shares at the lower price. You generally don’t want to hold on too long — things can change fast, or the stock could spike again.
You’ve got to remember this, though: regardless of whether the price goes up or down, you have to buy back the shares and…
4. Return the Shares
Now, you return the shares to your broker, safe and sound. If all went well, you keep the price difference, minus fees.
Sounds easy, right? Yes and no.
Short selling in and of itself isn’t a complicated process. However, learning how to make smart stock picks for short selling can be tricky. Don’t tread lightly when it comes to short selling. We’ll get into the risks in a little bit, but rest assured, they’re significant.
I’d never suggest short selling until you have a really good understanding of the patterns that go into it and a feel for the pace of it. Because when things go wrong with a short sale, they can REALLY go wrong.
Shorting a Stock Versus Buying a Put
If you’re into options trading, the process of short selling might sound a little bit like buying a put option.
And yes, both are bearish strategies. But they’re not the same thing.
With short selling, you’re selling a stock that you borrowed — you don’t own it. When you buy a put option, you gain the right to sell a stock at a specific price that’s higher than what you think the stock will be worth in the near future.
How Do You Make Money by Shorting a Stock?
I know what you really want to know: how can traders make money shorting a stock? Let’s walk through an example.
Disclaimer: The following is only an example and I’m in no way giving you financial advice. All trading and investing is risky. Never risk more than you can afford. Always do your due diligence.
Example of Shorting a Stock
Say that you see a stock trading for $5 per share. But you notice that the company is trading on BS news, and you don’t think that it can hold that price. You think the price will drop soon.
So you hit up your broker and borrow 1,000 shares. You sell them, and the price goes down to $2.
You buy back the shares at $2, then return them to your broker. Before fees, you’ve got about $3,000 in your pocket.
Short Selling for a Profit
In the above example, you get an idea of how a trader can short sell for a profit. The idea is that if you short sell a stock that’s experiencing a high but then decreases in price, you’ve got the potential for profits … But what if the trade doesn’t go well?
Short Selling for a Loss
Here’s where things can get scary with short selling. Say in the above example, you short sell shares of a stock at $5 each. But then, the price starts spiking … and goes up to $15 per share.
You’re still responsible for buying back and returning those shares to your broker. You stand to lose far more than you put into the trade.
Short Selling as a Hedge
In general, the stock markets go up more than they fall. All the same … bear markets are challenging. Fear of loss can lead to plenty of bad decisions.
Having a solid understanding of short selling can allow you to learn to hedge your portfolio, to use a long-short strategy, or to potentially profit from falling markets.
Pros of Short Selling
If you only trade stocks that you hope will go up in price, then you could be missing out on a ton of opportunities.
During a market downturn, for instance, you might just avoid trading.
Personally, I don’t think you should trade every day … only when best setups for your strategy come along. All the same, short selling can increase the number of opportunities you can find during different market conditions.
By adding short selling to your repertoire, you can learn to potentially profit in both bear and bull markets.
I’m not shorting right now, because there are a ton of wannabe short-sellers out there and that’s causing a ton of short squeezes.
But in the past, I’ve been an avid short seller. And if the right opportunity comes along, I might do it again. The key is adapting to and trading based on what’s currently happening in the market — not what you want to happen in the market.
Risks of Short Selling
You may have heard that short selling is risky. Guess what? You heard right.
The biggest risk involved with short selling? Your losses are unlimited. Yes, you heard that right. Unlimited losses.
When you take a long position, the worst case is if the stock drops to $0. Say you bought 1,000 shares at $30 each and the price goes down to $0. That will hurt … but your losses end there.
That’s not the case with short selling.
You could short sell 1,000 shares at $3 and watch the price skyrocket up to $30. In this case, you could lose even more than you put into the trade to begin with.
With a long position, you know exactly how much you could lose. But with short selling, you don’t know. That’s why you MUST do your research … and you MUST be prepared to cut losses quickly!
Costs of Short Selling
There are a few things you should know about the costs associated with short selling.
First, you won’t just find a loser stock and clean up on its free-fall. If a stock falls 10% over the previous day’s close, it’ll be under the alternative uptick rule. This is to keep speculative short selling from forcing prices down further.
Second, there are fees. There will be broker fees for the borrowed shares, and sometimes they fluctuate depending on supply and demand.
Third, as a short seller, you can be taxed at higher short-term capital gains tax rates, regardless of the duration of your position.
Finally, you can’t use the money you make from short selling right away. The money will be deposited in your account, but it won’t be available until your liability to return the shares is in compliance … that usually takes a few days.
7 Tips and Considerations for Short Selling
There’s a lot you need to know if you want to short sell. Here are just a few key tips and considerations.
Liquidity matters! Be extremely aware of the liquidity levels when considering any stock, but especially with stocks you want to short.
The lower the liquidity, the harder it is to get in or out of a position. Remember: when you buy, someone has to sell and vice versa. If shares aren’t moving, you can end up in a very uncomfortable position.
2. Margin Account
To take a short position, you’ll most likely need to open a margin account.
This means you might have to put up slightly more capital than if you were just planning on buying stocks. The amount of money you need to open an account will vary based on your broker.
When you utilize margin, your broker will charge you fees for lending you the shares that you want to short. The fees can vary depending on the stock float and the market conditions.
Also, the broker might ask for excess margin … So you might have to deposit extra money or collateral stocks, especially if volatility is high. This is kind of like their insurance policy on the loan they’re giving you since you could lose more than you have in your account.
3. Margin Call
The margin call is every short seller’s worst nightmare.
This means that you need to put more money into your account … but it also means that you have fairly large losses in your account.
By using margin, you’re basically taking out a loan from your broker. If you don’t put more money into your account, the trade will automatically be closed, canceling out your position. You could be stuck with a serious loss.
Wanna know more about margin trading and margin calls? Check out this post.
4. Short Squeeze
Another dreaded event for short-sellers? The short squeeze.
It works like this: If a lot of buyers come in all at once, the stock will shoot up in price. This could happen when a stock has a large number of shares shorted and a catalyst like good news.
Shorts will be rushing for the exit … and longs will be trying to buy up shares like crazy. This phenomenon can be more likely on Fridays. Hype can take over and shorts don’t want to be in losing positions over the weekend. So when shorts buy to cover, it drives the price up. Then longs start buying, driving the price up further.
As a short seller, you’ll inevitably experience this at some point. Be smart about it and cut your losses FAST.
5. Know How to Exit Your Position
You should always have a trading plan for every trade. This is where you determine your entry and exit positions beforehand. With short selling, it’s just as important.
But in addition to knowing when you’ll exit, you need to have an understanding of HOW to exit a short sale.
When you short a stock, you need to “buy to cover” when you want to exit the trade. Many people make the rookie mistake of filling out the trade order form incorrectly. Don’t be one of those jerks.
6. Stop Losses
I never use electronic stop losses. But that’s because I never trade when I can’t watch the trade really closely. Also, my positions are typically short-lived.
But if you plan to leave your computer when you enter a short position, have a stop loss in place.
If you don’t, the stock could rise rapidly, and you risk losing far more money than you ever thought. A stop-loss will automatically exit you from the position if the stock hits a certain level.
This one may not be relevant to a lot of penny stocks and micro-cap stocks since few of them offer dividends … but it’s still worth knowing if you want to sell short.
If you short a stock at the market close the day before the ex-dividend date, you owe the dividend. This means it will be deducted from your trading account and paid to the person who actually owns the shares.
For example, say you borrow 100 shares of company XYZ, and then company XYZ declares a dividend of 14 cents per share. You need to pay out $14.
It doesn’t seem like a lot, but if you borrow 1,000 or even more shares of XYZ, it becomes a bigger deal.
A lot of short-sellers lose money. One big reason is that a lot of them don’t take the time to learn how to trade before they start throwing money at the market.
Don’t make that mistake. Before you put money in the market, be an investor … in your education. If you want to learn the rhythms of the market and get up to speed fast, consider joining my Trading Challenge.
I’m looking for students and traders who want to develop skills and a knowledge base. I want students who strive to become strong, self-sufficient traders.
Your trading mindset is SO important … I only want students who are willing to study and work hard.
I created the Trading Challenge based on my two-plus decades of experience. I want you to benefit from my knowledge and learn what I had to find out the hard way.
I’ve got a ton of resources for you — videos, webinars, and live trading webcasts … plus, you can see every trade I make. And don’t forget: some of my students are teachers, too! Get a solid start with “The Complete Penny Stock Course,” a book by my student Jamil (I wrote the forward).
I don’t want you to memorize patterns. I want you to UNDERSTAND them. This is how you can become adapt to and spot opportunities in any type of market.
Ready to invest in your trading future? Apply for my Trading Challenge today.
The Final Word on Short Selling Stocks
Short selling can be scary and risky … so if you’re going to try this strategy, build your knowledge account first.
Whether you go long or short in the markets, it’s your job to learn and understand as much as you can before you make a single trade.
If you want to short stocks, you gotta be diligent about doing your research. You also need to learn how to recognize key patterns and get a good grasp of how the process actually works. Reading this post is a good start. But your education is far from over. Keep it going strong every day — your market education never really ends.
And if you’re ready to dedicate yourself to learning the process, consider applying for my Trading Challenge. Knowledge is power when it comes to trading, and that’s especially true for short selling.
I want to know what you think … Do you short sell stocks? Why or why not?
How much has this post helped you?
Tim Sykes is a penny stock trader and teacher who became a self-made millionaire by the age of 22 by trading $12,415 of bar mitzvah money. After becoming disenchanted with the hedge fund world, he established the Tim Sykes Trading Challenge to teach aspiring traders how to follow his trading strategies. He’s been featured in a variety of media outlets including CNN, Larry King, Steve Harvey, Forbes, Men’s Journal, and more. He’s also an active philanthropist and environmental activist, a co-founder of Karmagawa, and has donated millions of dollars to charity. Read More
Have What It Takes To Become Successful?
Let Me Walk You Step-by-Step Through How I Earn Profits.
Take Action Now.
Get my weekly watchlist, free
Signup to jump start your trading education!
Tim’s Best Content
- All Time
- Case Studies
Millionaire Mentor Update: One Trade at a Time
WARNING: Fake Sykes Scammers Want Your Money
How to Make Penny Stock
Top Penny Stocks to Watch for April 2020
Top Trading Patterns in the Coronavirus Market
Millionaire Mentor Update: Penny Stock Strategies For a ‘Fire at Will’ Market
Penny Stocks 101
The Best Video Lessons Every Penny Stock Trader And Short Seller Should Watch
10 Key Stock Market Lessons From My First Millionaire Student**
5 Lessons From My Steve Harvey Show Interview
How I Helped A Student Turn $1,500 into $1 Million in 3 Years
My Review Of ‘Trading Tickers’ The Best Stock Trading Guide Ever Created
Case Study: How I Taught Tim Grittani To Make 1075% Return In 16 Months
Case Study: How I Helped a Mother of Two Become a Full Time Trader
Day Trading Testimonials
“I’m a 29 year old single mother of two. I do not have a regular 9 to 5. I am currently day trading as a living. Prior to discovering Timothy Sykes I played around with a couple other mentors and penny pick sites. Sadly not being taught the basic fundamentals I lost $5500-Terrible! I found Tim’s website in May and now I’m up 50k learning from Tim Sykes. I am extremely grateful for Tim, he is the truth hands down!”
– Asheya Burton
Learn How I Turned $12,415 into $5,119,603 Trading Stocks
– Timothy Sykes of Profit.ly
Comments ( 9 )
As many of you already know I grew up in a middle class family and didn’t have many luxuries. But through trading I was able to change my circumstances –not just for me — but for my parents as well. I now want to help you and thousands of other people from all around the world achieve similar results!
Which is why I’ve launched my Trading Challenge. I’m extremely determined to create a millionaire trader out of one my students and hopefully it will be you.
So when you get a chance make sure you check it out.
PS: Don’t forget to check out my free Penny Stock Guide, it will teach you everything you need to know about trading.
Thanks Tim, helped me a lot. What I still don‘t get is how can I find out if my broker has shorts of a partcular stock I wanna trade
Thanks Tim, helped me a lot. What I still don‘t get is how can I find out if my broker has shorts of a partcular stock I wanna trade.
This is informative, however, I haven’t gone through the video or lesson that shows/tells exactly how, as a trader we are supposed to make the trade correctly and not get ourselves in quicksand. I understand you have to work with your broker to find out if they will find and reserve shorts for you, I get you have a negative number, I don’t get how you set up the fill, or is it the buy?
I am studying you buns off, my comprehension level is increasing, I don’t have to go look up all the terms like I did in the beginning of learning. I still have to look up some new ones I haven’t heard before.
Thank you for all you do.
I am saving this for later. I have decided to start reading through your contents, and watching the Youtube videos on my way to work, which is like a 1 hr tram ride. I’m so excited to learn and I am SO very grateful for all the amazing content you share with us all! Thank you, truly! ❤
This article makes a lot more sense this time around. I’ve papertraded a short twice. I didn’t understand all the fees that are related to short selling. This cleared a lot of that up, I’m sure there’s still part of it that isn’t totally clear. When I first heard of short selling it made sense to me mathematically, I thought that’s the trading that I’d like to do. Learning more about it, I want a lot more education and practice before short selling. However, it’s up to the stocks not me I will adapt to the market so I can become a self sufficient trader. Thank you.
Leave a Reply Cancel reply
About Timothy Sykes
I became a self-made millionaire by the age of 21, trading thousands of Penny Stocks – yep you read that right, penny stocks. You may have heard . Read more
Tim’s Important Resources
** Results may not be typical and may vary from person to person. Making money trading stocks takes time, dedication, and hard work. There are inherent risks involved with investing in the stock market, including the loss of your investment. Past performance in the market is not indicative of future results. Any investment is at your own risk. See Terms of Service here..
Millionaire Media 80 S.W. 8th Street Suite 2000 Miami, Florida 33130 United States (203) 980-1361 This is for information purposes only as Millionaire Media LLC nor Timothy Sykes is registered as a securities broker-dealer or an investment adviser. No information herein is intended as securities brokerage, investment, tax, accounting or legal advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation or sponsorship of any company, security or fund. Millionaire Media LLC and Timothy Sykes cannot and does not assess, verify or guarantee the adequacy, accuracy or completeness of any information, the suitability or profitability of any particular investment, or the potential value of any investment or informational source. The reader bears responsibility for his/her own investment research and decisions, should seek the advice of a qualified securities professional before making any investment, and investigate and fully understand any and all risks before investing. Millionaire Media LLC and Timothy Sykes in no way warrants the solvency, financial condition, or investment advisability of any of the securities mentioned in communications or websites. In addition, Millionaire Media LLC and Timothy Sykes accepts no liability whatsoever for any direct or consequential loss arising from any use of this information. This information is not intended to be used as the sole basis of any investment decision, nor should it be construed as advice designed to meet the investment needs of any particular investor. Past performance is not necessarily indicative of future returns.
©2007-2020 TimothySykes™ All Rights Reserved. Millionaire Publishing LLC
Shorting a Stock: Seeking the Upside of Downside Markets
Short selling aims to provide protection or profit during a stock market downturn, but it can be risky. Plus, it requires a margin account. Learn the mechanics of shorting a stock.
- Short selling aims to profit from stocks that decline in value
- Shorting a stock requires margin account privileges
- Learn the mechanics, and the potential benefits and risks, of shorting a stock
If anything is certain about the markets, it’s that they fluctuate. They go up and they go down. Bull markets and bear markets. It’s like traveling a mountain range, across peaks and valleys. Sure, over longer periods, the upward cycles in the stock market tend to be larger than the downward cycles, but many of the downturns have been steeper and faster. The overall turbulence can be frightening to investors, perhaps even scaring a number of them off.
Perhaps you’re wondering if there’s any way to capture the upside during a market downturn, or more specifically, any way to profit when a stock, sector, industry, or the broader market enters a short-term correction or a longer-term bear market. The answer, with a few caveats that we’ll explore, is yes. Investors can profit from a market decline.
What Does It Mean to Short a Stock?
You’re probably familiar with the terms “short selling,” “going short the stock market,” “shorting a stock,” or “selling stocks short.” The aim when shorting a stock is to generate profit from stocks that decline in value. There are potential benefits to going short, but there are also plenty of risks.
We also can’t neglect the stigma attached to short selling. After all, shorting a stock is all about generating profit from a company’s partial or total decline. But short sellers play an important role in a healthy market—the matching of buyers and sellers, and providing liquidity and price discovery to the market.
So if you’re new to this way of shorting stocks as part of an investment strategy and would like to learn more, let’s start by exploring the basic mechanics of a short sale.
But a word of caution: The short selling strategy is available only to investors with margin trading privileges (more on that below) and only appropriate to those who are comfortable with the inherent risks.
How Does Short Selling Work?
Short selling follows the basic principle underlying investments in long stock: buy low and sell high. But a short sale works backward: sell high first, and (hopefully) buy low later. But how can you sell a stock that you don’t already own?
You “borrow” it from another investor with the help of your brokerage firm. Here’s an example.
Shorting a Stock: A Hypothetical Example
Suppose there’s a stock trading at $40 that you believe to be overpriced, and you’d like to get short to take advantage of a potential move to the downside.
- You place an order to sell short 100 shares of stock XYZ at the price of $40.
- Your broker “borrows” the shares, fills your order, and places them into your account; you are now “net short” $4,000 worth of XYZ stock (100 shares at $40 = $4,000).
- Stock XYZ falls in price to $35.
- You sold at $40 and decide to capture the profit. You “buy” at $35 to close your position, pocketing the difference of $500 (100 shares at $5) minus any transaction costs.
A word on dividends: If the company paid any dividends during the time you were short, your account would be reduced by the amount of the dividend. Why? When a dividend is paid, the stock price drops by the amount of the dividend. For example, if a stock is at $40 and the company pays a $1 dividend, the owner of record gets the $1, and the stock value is reduced, all else equal, to $39. So if you held a short position on the ex-dividend date, you ’d get the benefit of the stock drop, but you ’d essentially “pay” the dividend. In and out.
- Stock XYZ rises by $5 to $45.
- This position has moved against you, as you sold short at $40 and now have to buy it back at a higher price. You decide to buy at $45, losing $500 (100 shares at $5) plus any transaction costs, as well as any dividends you might have paid along the way.
In a nutshell, that’s how short selling works.
But there’s one more step that might make things slightly more complicated.
To Sell Stocks Short, You Need to Open a Margin Account
Some investors and traders use margin in several ways. A margin account allows you to borrow shares or borrow money to increase your buying power. In this case, you can sell short marginable stock with up to twice the buying power of a traditional cash account. The securities you hold in your account act as collateral for the loan, and you pay interest on the money borrowed.
- To qualify for a margin trading account, you need to apply, and you must have at least $2,000 in cash equity or eligible securities.
- When you use margin, you must maintain at least 30% of the total value of your position as equity at all times. If market fluctuations reduce the value of the equity in your account, your broker may issue a margin call, which you must meet by adding funds to your account. If you fail to meet a margin call, your broker could buy back your short position.
The traditional margin trading example is summarized in figure 1.
Margin accounts and margin trading can be risky, so it’s important to understand the risks before you jump in. If you’re interested in applying for margin trading privileges, log in to your account and follow the instructions in figure 2 below.
Potential Benefits and Risks of Short Selling
Let’s start with the potential benefits:
Interested in margin privileges?
Learn the benefits and risks of margin trading.
- Profiting from downturns. Short selling allows you to seek positive returns during a market downturn.
- Hedging your “long” positions. You can use short selling to hedge stocks you already own. For instance, you can short a sector ETF to help hedge a number of related sector stocks that you may be holding in your portfolio.
- Playing both sides of the market. You can consider going long on stocks you expect to outperform while going short on stocks that you expect to underperform. You could even consider buying (going long) and selling (going short) two highly correlated stocks that have moved far apart and that you expect to converge.
- Diversifying a portfolio. If a portfolio is completely made up of long positions, a margin account could allow you to further diversify in a market downturn (what’s known as systematic risk) by having both long and short positions. Also, if your portfolio is dominated by a large position in one stock, a margin account could allow you to diversify your portfolio without having to sell your current shares of stock. This strategy can be particularly helpful if you have a large unrealized capital gain and want to try to keep it that way.
And now, a few of the risks:
- Unlimited risk. Because there is technically no limit to how high a stock or ETF price can rise, your risk of loss in short selling is unlimited.
- Dividends and other payments. You’re responsible for any dividends, stock splits, or spin-offs paid on the borrowed stock.
- Unfavorable liquidation. You may be required to close your short positions at unfavorable prices, particularly in cases where your stock experiences a sharp surge in price.
- Historical upward trend. Historically, the broader stock market has risen over time. Though past performance is no guarantee of future results, the market’s tendency to rise over time remains a potential risk for any short seller.
To Short or Not to Short Stocks?
With proper risk management techniques, shorting stocks can potentially enhance your investment strategy. But it isn’t for every investor.
If you’re not sure whether short selling or margin trading might be appropriate for your financial profile, risk tolerance, or financial goals, contact a representative for assistance in making the assessment. For additional videos, resources, and support on margin trading, visit this TD Ameritrade margin trading page.
Shorting a stock allows you to sell something you don’t own, so traders must understand the regulatory requirements. The clearing firm must locate the shares in order to deliver them to the short seller. Shares may be hard to borrow because of high demand, a small number of outstanding shares (“float”), or increased securities volatility. If the stock loan department is unable to deliver the shares for settlement, it may call for a “buy-in,” meaning the borrower must buy the shares in the open market to cover the position. If the stock price has increased, the borrower will lose money.
Also, borrowers of certain “hard-to-borrow” (HTB) shares may be subject to an additional fee in order to compensate the stock loan department for the cost of locating and maintaining its supply of such HTB shares. If you open and close a short position intraday (meaning you don’t hold it overnight), you will not be subject to a fee. However, if you hold the position longer, an HTB fee, based on the notional value of the short position and the annualized HTB rate, will be assessed.
How are HTB fees calculated? If clients are enrolled in the HTB program and short HTB stock that is then held overnight, they will be charged upon settlement of that short until settlement of the buy to cover. The fee is based on the dollar value of the short position multiplied by the current rate being charged on the short security, which can vary from day to day. It is quoted as a percentage of the value of the short position (such as -3.5% annualized). This rate is representative of the demand/price within the securities lending market. Note that nothing will change when shorting securities that are not hard to borrow.
Stock markets are measured by stock indexes (or indices), such as the Dow Jones Industrial Average (DJIA) in New York, and the FTSE 100 index (often called the Footsie) in London. These indexes show changes in the average prices of a selected group of important stocks. There have been several stock market crashes when these indexes have fallen considerably on a single day (e.g. ‘Black Monday 5 , 19 October 1987, when the DJIA lost 22.6%).
Financial journalists use some animal names to describe investors:
■ bulls are investors who expect prices to rise
■ bears are investors who expect them to fall
■ stags are investors who buy new share issues hoping that they will be over-subscribed. This means they hope there will be more demand than available stocks, so the successful buyers can immediately sell their stocks at a profit.
A period when most of the stocks on a market rise is called a bull market. A period when most of them fall in value is a bear market.
Dividends and capital gains
Companies that make a profit either pay a dividend to their stockholders, or retain their earnings by keeping the profits in the company, which causes the value of the stocks to rise. Stockholders can then make a capital gain – increase the amount of money they have – by selling their stocks at a higher price than they paid for them. Some stockholders prefer not to receive dividends, because the tax they pay on capital gains is lower than the income tax they pay on dividends. When an investor buys shares on the secondary market they are either cum div, meaning the investor will receive the next dividend the company pays, or ex div, meaning they will not. Cum div share prices are higher, as they include the estimated value of the coming dividend.
Institutional investors generally keep stocks for a long period, but there are also speculators – people who buy and sell shares rapidly, hoping to make a profit. These include day traders – people who buy stocks and sell them again before the settlement day. This is the day on which they have to pay for the stocks they have purchased, usually three business days after the trade was made. If day traders sell at a profit before settlement day, they never have to pay for their shares. Day traders usually work with online brokers on the internet, who charge low commissions – fees for buying or selling stocks for customers. Speculators who expect a price to fall can take a short position, which means agreeing to sell stocks in the future at their current price, before they actually own them. They then wait for the price to fall before buying and selling the stocks. The opposite – a long position – means actually owning a security or other asset: that is buying it and having it recorded in one’s account.
June 1: Sell 1,000 Microsoft stocks, to be delivered June 4, at current market price: $26.20 June 3: Stock falls to $25.90. Buy 1,000
June 4: Settlement day. Pay for 1,000 stocks @ $25.90, receive 1,000 x $26.20. Profit $300
A short position
31.1 Label the graph with words from the box. Look at A opposite to help you.
bull market crash
1984 1985 1986 1987 1988
31.2 Answer the questions. Look at A, B and C opposite to help you.
1 How do stags make a profit?
2 Why do some investors prefer not to receive dividends?
3 How do you make a profit from a short position?
31.3 Make word combinations using a word or phrase from each box. Some words can be used twice. Then use the correct forms of the word combinations to complete the sentences below. Look at B and C opposite to help you.
make a capital gain own a dividend pay earnings receive a position retain a profit take securities tax
1 I. less. on capital gains
than on income. So as a shareholder, I prefer
not to. a. If the
company. its. , I can
selling my shares at a profit instead.
2 Day trading is exciting because if a share price
falls, you can. a. by
. a short. But it’s risky
Would you like to be
selling. that you don’t even
The sculpture of a bull near the New York Stock Exchange
a day trader? Or would you be frightened of taking such risks?
Influences on share prices
Share prices depend on a number of factors:
■ the financial situation of the company
■ the situation of the industry in which the company operates
■ the state of the economy in general
■ the beliefs of investors – whether they believe the share price will rise or fall, and whether they believe other investors will think this.
Prices can go up or down and the question for investors – and speculators – is: can these price changes be predicted, or seen in advance? When price-sensitive information – news that affects a company’s value – arrives, a share price will change. But no one knows when or what that information will be. So information about past prices will not tell you what tomorrow’s price will be.
There are different theories about whether share price changes can be predicted.
■ The random walk hypothesis. Prices move along a ‘random walk’ – this means day-today changes arc completely random or unpredictable.
■ The efficient market hypothesis. Share prices always accurately or exactly reflect all relevant information. It is therefore a waste of time to attempt to discover patterns or trends – general changes in behaviour – in price movements.
Head and shoulders pattern
■ Technical analysis. Technical analysts are people who believe that studying past share prices does allow them to forecast future price changes. They believe that market prices result from the psychology of investors rather than from real economic values, so they look for trends in buying and selling behaviour, such as the c head and shoulders’ pattern.
■ Fundamental analysis. This is the opposite of technical analysis: it ignores the behaviour of investors and assumes that a share has a true or correct value, which might be different from its stock market value. This means that markets are not efficient. The true value reflects the present value of the future income from dividends.
Analysts distinguish between systematic risk and unsystematic risk. Unsystematic risks are things that affect individual companies, such as production problems or a sudden fall in sales. Investors can reduce these by having a diversified portfolio: buying lots of different types of securities. Systematic risks, however, cannot be eliminated in this way. For example market risk cannot be avoided by diversification: if a stock market falls, all the shares listed on it will fall to some extent.
32.1 Match the two parts of the sentences. Look at A and B opposite to help you.
1 The random walk theory states that
2 The efficient market hypothesis is that
3 Technical analysts believe that
4 Fundamental analysts believe that
a studying charts of past stock prices allows you to predict future changes,
b stocks are correctly priced so it is impossible to make a profit by finding undervalued ones,
c you can calculate a stock’s true value, which might not be the same as its market price,
d it is impossible to predict future changes in stock prices.
32.2 Are the following statements true or false? Find reasons for your answers in B and C opposite.
1 Fundamental analysts think that stock prices depend on psychological factors – what people think and feci – rather than pure economic data.
2 Fundamental analysts say that the true value of a stock is all the income it will bring an investor in the future, measured at today’s money values.
3 Investors can protect themselves against unknown, unsystematic risks by having a broad collection of different investments.
4 Unsystematic risks can affect an investor’s entire portfolio.
32.3 Match the theories (1-3) to the statements (a-c). Look at B opposite to help you.
1 fundamental analysis
2 technical analysis
3 efficient market hypothesis
Share prices are correct at any given time. When new information appears,
they change to a new correct price.
By analysing a company, you can determine its real value. This sometimes allows you to make a profit by buying underpriced shares.
It’s not only the facts about a company that matter: the stock price also depends on what investors think or feel about the company’s future.
Do you believe that it is possible to find undervalued stocks, predict future price and regularly get returns that are higher than the stock market average?
Government and corporate bonds
Bonds are loans to local and national governments and to large companies. The holders of bonds generally receive fixed interest payments, once or twice a year, and get their money – known as the principal – back on a given maturity date. This is the date when the loan ends.
Governments issue bonds to raise money and they are considered to be a risk-free investment. In Britain government bonds are known as gilt-edged stock or just gilts. In the US they are called Treasury notes, which have a maturity of 2-10 years, and Treasury bonds, which have a maturity of 10-30 years. (There are also short-term Treasury bills which have a different function: see Units 25 and 27.)
Companies issue bonds, called corporate bonds, because they can usually pay less interest to bondholders than they would have to pay if they raised the same money by a bank loan. These bonds are generally safer than shares, because if a company cannot repay its debts it can be declared bankrupt. If this happens, the creditors can force the company to stop doing business, and sell its assets to repay them. In this way, bondholders will probably get some of their money back.
Borrowers – the companies issuing bonds – are given credit ratings by credit agencies such as Standard & Poor’s and Moody’s. This means that they are graded, or rated, according to their ability to repay the loan to the bondholders. The highest grade (AAA or Aaa) means that there is almost no risk that the borrower will default – fail to pay interest or to repay the principal. Lower grades (e.g. Baa, BBB, C, etc.) mean an increasing risk of the borrower becoming insolvent – unable to pay interest or repay the capital.
Prices and yields
Bonds are traded by banks which act as market makers for their customers, quoting bid and offer prices with a very small spread or difference between them. (See Unit 30) The price of bonds varies inversely with interest rates. This means that if interest rates rise, so that new borrowers have to pay a higher rate, existing bonds lose value. If interest rates fall, existing bonds paying a higher interest rate than the market rate increase in value. Consequently the yield of a bond – how much income it gives – depends on its purchase price as well as its coupon or interest rate. There are also floating-rate notes – bonds whose interest rate varies with market interest rates.
Other types of bonds
When interest rates are high, some companies issue convertible shares or convertibles, which are bonds that the owner can later change into shares. Convertibles pay lower interest rates than ordinary bonds, because the buyer gets the chance of making a profit with the convertible option.
There are also zero coupon bonds that pay no interest but are sold at a big discount on their par value, which is 100%, and repaid at 100% at maturity. Because they pay no interest, their owners don’t receive money every year (and so don’t have to decide how to reinvest it); instead they make a capital gain at maturity.
Bonds with a low credit rating (and a high chance of default), but paying a high interest rate, are called junk bonds. Some of these are known as fallen angels – bonds of companies that were previously in a good financial situation, while others are issued to finance leveraged buyouts. (See Unit 40)
BrE: convertible share; AmE: convertible bond
33.1 Match the words in the box with the definitions below. Look at A and B opposite to help you.
coupon maturity date credit rating principal gilt-edged stock Treasury bonds default Treasury notes insolvent yield
1 the amount of capital making up a loan
2 an estimation of a borrower’s solvency or ability to pay debts
3 bonds issued by the British government
4 non-payment of interest or a loan at the scheduled time
5 the day when a bond has to be repaid
6 long-term bonds issued by the American government
7 the amount of interest that a bond pays
8 medium-term (2-10 year) bonds issued by the American government
9 the rate of income an investor receives from a security 10 unable to pay debts
33.2 Are the following statements true or false? Find reasons for your answers in A, B and C opposite.
1 Bonds are repaid at 100% when they mature, unless the borrower is insolvent.
2 Bondholders are guaranteed to get all their money back if a company goes bankrupt.
3 AAA bonds are a very safe investment.
4 A bond paying 5% interest would gain in value if interest rates rose to 6%.
5 The price of floating-rate notes doesn’t vary very much, because they always pay market interest rates.
6 The owners of convertibles have to change them into shares.
7 Some bonds do not pay interest, but are repaid at above their selling price.
8 Junk bonds have a high credit rating, and a relatively low chance of default.
33.3 Answer the questions. Look at A, B and C opposite to help you.
1 Which is the safest for an investor?
A a corporate bond B a junk bond C a government bond
2 Which is the cheapest way for a company to raise money?
A a bank loan B an ordinary bond C a convertible
3 Which gives the highest potential return to an investor?
A a corporate bond B a junk bond C a government bond
4 Which is the most profitable for an investor if interest rates rise?
A a Treasury bond B a floating-rate note C a Treasury note
Is this a good time to buy bonds? Why/why not?
Forward and futures contracts are agreements to sell an asset at a fixed price on a fixed date in the future. Futures are traded on a wide range of agricultural products (including wheat, maize, soybeans, pork, beef, sugar, tea, coffee, cocoa and orange juice), industrial metals (aluminium, copper, lead, nickel and zinc), precious metals (gold, silver, platinum and palladium) and oil. These products are known as commodities. Futures were invented to enable regular buyers and sellers of commodities to protect themselves against losses or to hedge against future changes in the price. If they both agree to hedge, the seller (e.g. an orange grower) is protected from a fall in price and the buyer (e.g. an orange juice manufacturer) is protected from a rise in price.
Futures are standardized contracts – contracts which are for fixed quantities (such as one ton of copper or 100 ounces of gold) and fixed time periods (normally three, six or nine months) – that are traded on a special exchange. Forwards are individual, non- standardized contracts between two parties, traded over-the-counter – directly, between two companies or financial institutions, rather than through an exchange. The futures price for a commodity is normally higher than its spot price – the price that would be paid for immediate delivery. Sometimes, however, short-term demand pushes the spot price above the future price. This is called backwardation.
Futures and forwards are also used by speculators – people who hope to profit from price changes.
More recently, financial futures have been developed. These are standardized contracts, traded on exchanges, to buy and sell financial assets. Financial assets such as currencies, interest rates, stocks and stock market indexes fluctuate – continuously vary – so financial futures are used to fix a value for a specified future date (e.g. sell euros for dollars at a rate of € 1 for $1.20 on June 30).
■ Currency futures and forwards are contracts that specify the price at which a certain currency will be bought or sold on a specified date.
■ Interest rate futures are agreements between banks and investors and companies to issue fixed income securities (bonds, certificates of deposit, money market deposits, etc.) at a future date.
■ Stock futures fix a price for a stock and stock index futures fix a value for an index (e.g. the Dow Jones or the FTSE) on a certain date. They are alternatives to buying the stocks or shares themselves.
Like futures for physical commodities, financial futures can be used both to hedge and to speculate. Obviously the buyer and seller of a financial future have different opinions about what will happen to exchange rates, interest rates and stock prices. They are both taking an unlimited risk, because there could be huge changes in rates and prices during the period of the contract. Futures trading is a zero-sum game, because the amount of money gained by one party will be the same as the sum lost by the other.
34.1 Match the words in the box with the definitions below. Look at A opposite to help you
backwardation commodities forwards futures to hedge over-the-counter spot price
1 the price for the immediate purchase and delivery of a commodity
2 the situation when the current price is higher than the future price
3 adjective describing a contract made between two businesses, not using an exchange
4 contracts for non-standardized quantities or time periods
5 physical substances, such as food, fuel and metals, that can be bought or sold with futures contracts
6 to protect yourself against loss
7 contracts to buy or sell standardized quantities
34.2 Complete the sentences using a word or phrase from each box. Look at A and B opposite to help you.
u banks v companies w farmers
A Commodity futures allow B Interest rate futures allow C Currency futures allow
x food manufacturers y importers z investors
1 to charge a consistent price for their products.
2 to be sure of the rate they will get on bonds which could be
issued at a different rate in the future.
3 to know at what price they can borrow money to finance
4 to make plans knowing what price they will get for their crops.
5 to offer fixed lending rates.
6 . to remove exchange rate risks from future international
34.3 Are the following statements true or false? Find reasons for your answers in B opposite.
1 Financial futures were created because exchange rates, interest rates and stock prices all regularly change.
2 Interest rate futures are related to stocks and shares.
3 Financial futures contracts allow companies to protect themselves against short-term changes in exchange rates.
4 You can only hedge if someone who expects a price to move in the opposite direction is willing to buy or sell a contract.
5 Both parties can make money out of the same futures contract.
Look at some commodity prices, and decide if you think they will rise or fall over the next three months. Check in three months 1 time to see if you would have made or lost money by buying or selling futures.Best Binary Options Brokers 2020:
Best Choice For Beginners!
Free Trading Education!
Free Demo Account!
Big Sign-up Bonus!
Perfect For Experienced Traders!