New York - Aggressive investors can use selling short to profit when a stock declines. When you sell stock short, you are actually borrowing shares from your broker, selling them, and keeping the proceeds. You should only sell a stock short if you believe that it will go down and that you can buy and return the shares to your broker at a lower cost that what you originally shorted it. Here are two examples:
Example #1
|
Sell 100 shares at $50 |
$5,000 |
|
Buy 100 shares at $60 |
$6,000 |
|
Net profit (loss) equals |
($1,000) |
|
Unannualized investment return |
20% |
Example #2
|
Sold short 100 shares at $50 |
$5,000 |
|
Buy back 100 shares at $40 |
$4,000 |
|
Net profit (loss) equals |
$1,000 |
|
Unannualized investment return |
20% |
Example #2 illustrates a profitable short sale while example #1 shows a loss. Both examples do not include the effects of brokerage commissions or any dividends that you would actually pay if you the company paid a dividend. Remember, you only borrowed the stock and you would owe the dividends to the rightful owner.
Selling stock short has advantages. Just as you can find a stock that will go down - you may believe a stock is significantly overvalued; hence, this method allows you to profit on your belief. At year end, it is an excellent method to defer paying taxes on a stock that you want to sell but lock in built-up profits. For instance, if you short a stock in December and buy it back in January, you have effectively locked in your profit and would defer taxes until the following year.
Keep in mind the following characteristics when considering selling short:
- Losses can be unlimited. You can lose many time the value of your initial investment if the stock you short keeps going up and if you never by it back.
- You can only short a stock after it has moved up by at least 1/16.
- Profits will be taxed as short-term capital gain and not the lower long-term capital gain
- You must have a margin account to make a short sale. Hence, you are subject to margin calls if the stock you shorted increases quickly.
- Your broker has the ability to "call" back the stock at any time - should the original owner wish to sell it. This could substantially impact your investment strategy and goals.
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