In financial terms, what is short selling?
For the many of you who are like me certain stock market terminology and rules might be a little confusing. In today’s environment I feel the more informed that we are the better decisions we will make. One of the most confusing concepts that I have never been able to really grasp has been the subject of “short selling”. However, I figure that maybe if I write about it in my blog, it might be a little more understandable for everyone.
There are two basic strategies (that I know of) when buying and selling stocks. First there is the long sale. That is when you believe that the stock you are buying is going to go up. That is a very basic rule. You buy at price X. If price X goes up 50 points (or dollars) then your stock is worth X plus $50. The same concept applies if your stock goes down. Say your stock goes down $50 instead, then your stock is worth X less $50.
Short selling is a strategy based on the idea that the stock is going to go down. The concept is kind of confusing but if you think about it a little you can figure it out. First of all, with short selling a broker “lends” an investor a certain amount of stock shares with the promise that the investor will return back to the broker the same number of shares at an unspecified date. If the price of the stock goes down, then you will have to pay back the broker at the new lower price. Furthermore, the investor gets to pocket the difference. For example you borrow 500 shares of Xyz Company from your broker for $50. The stock price then falls down to $10. You can then pay back the shares at the lower price and pocket the difference. However if the stock goes up you will be forced to pay back the shares at the higher price and you will be forced to pay the difference. The potential for making a big profit by short selling stocks is very good (especially in today’s bear market). However, the losses that can be accumulated should the investors theory that the stock will go down in value can be huge as well.
Many people feel that short selling has caused some of the problems that we are facing on Wall Street today. Lately, investors have been selling short financial stocks and reaping in big profits. However, there are others that argue that short selling has caused many of these stocks down spiral downward in price. There is a growing sector of the population that feels short selling should be banned. However, there are many that would argue otherwise. Representative Barney Frank is taking about bring back the “up tick “ rule. According to investorpedia.com, the uptick rule is explained as follows:
“A former rule established by the SEC that requires that every short sale transaction be entered at a price that is higher than the price of the previous trade. This rule was introduced in the Securities Exchange Act of 1934 as Rule 10a-1. The uptick rule prevents short selling from adding to the downward momentum when the price of an asset is already experiencing sharp declines”
At this point I do not understand 100% what this rule means. I do know that many experts say that reinstating the uptick rule will prevent stocks from spiraling downwards by short sellers. The reinstatement of this rule should hopefully also re instill investor confidence in the markets once again.
For the many of you who are like me certain stock market terminology and rules might be a little confusing. In today’s environment I feel the more informed that we are the better decisions we will make. One of the most confusing concepts that I have never been able to really grasp has been the subject of “short selling”. However, I figure that maybe if I write about it in my blog, it might be a little more understandable for everyone.
There are two basic strategies (that I know of) when buying and selling stocks. First there is the long sale. That is when you believe that the stock you are buying is going to go up. That is a very basic rule. You buy at price X. If price X goes up 50 points (or dollars) then your stock is worth X plus $50. The same concept applies if your stock goes down. Say your stock goes down $50 instead, then your stock is worth X less $50.
Short selling is a strategy based on the idea that the stock is going to go down. The concept is kind of confusing but if you think about it a little you can figure it out. First of all, with short selling a broker “lends” an investor a certain amount of stock shares with the promise that the investor will return back to the broker the same number of shares at an unspecified date. If the price of the stock goes down, then you will have to pay back the broker at the new lower price. Furthermore, the investor gets to pocket the difference. For example you borrow 500 shares of Xyz Company from your broker for $50. The stock price then falls down to $10. You can then pay back the shares at the lower price and pocket the difference. However if the stock goes up you will be forced to pay back the shares at the higher price and you will be forced to pay the difference. The potential for making a big profit by short selling stocks is very good (especially in today’s bear market). However, the losses that can be accumulated should the investors theory that the stock will go down in value can be huge as well.
Many people feel that short selling has caused some of the problems that we are facing on Wall Street today. Lately, investors have been selling short financial stocks and reaping in big profits. However, there are others that argue that short selling has caused many of these stocks down spiral downward in price. There is a growing sector of the population that feels short selling should be banned. However, there are many that would argue otherwise. Representative Barney Frank is taking about bring back the “up tick “ rule. According to investorpedia.com, the uptick rule is explained as follows:
“A former rule established by the SEC that requires that every short sale transaction be entered at a price that is higher than the price of the previous trade. This rule was introduced in the Securities Exchange Act of 1934 as Rule 10a-1. The uptick rule prevents short selling from adding to the downward momentum when the price of an asset is already experiencing sharp declines”
At this point I do not understand 100% what this rule means. I do know that many experts say that reinstating the uptick rule will prevent stocks from spiraling downwards by short sellers. The reinstatement of this rule should hopefully also re instill investor confidence in the markets once again.
Labels: Barney Frank, Securities and Exchange Commission, short selling, stock market terminology, uptick rule
Credit Card / Financial news blog post by Todd Holliday at 6:53 PM 